Suppose that you are 25 years old and are thinking about saving for retirement. Your plan is to save enough so that you can support yourself from the ages of 66 through 95 (30 years). You have two options. Under Plan A, you could save $2500 per year for the next 20 years, let it sit for 20 years and then draw on it for the following 30 years. Under Plan B you could wait 20 years and save $12,000 per year from ages 46 through 65 before drawing on the money for the following 30 years.
Suppose that you expect your investment to grow at 7% per year until you reach age 65. This rate of return is just below the historical average rate of return on common stocks in the US. After age 65, you plan to draw a constant annual income out of your account such that it is empty after 30 years of retirement. During this 30-year period, you will keep your money in a less risky portfolio that you expect to grow at 4% per year.
a.) Which plan will leave you wealthier in your retirement?
b.) How much could you afford to draw out each year during retirement under these two plans?
c.) Suppose that the inflation rate is expected to be 2% per year every year until you are 95. In current dollars, how much could you afford to draw out each year during retirement under the two plans above?
(Be careful, the amount that you're putting away has not changed. All that has changed is the units in which you are measuring the money that you take out - you now want a constant REAL income during retirement.)