So you are saving all this money for retirement but how do you know if you are on track to meet your goal? Are you saving too little or too much (…never an issue, of course). This goal-based investment plan addresses all these questions and more for a hypothetical 30-year old couple just about starting out in life with a net worth (not including the equity in their home) of about $100,000. Their goal is to retire at 65 (year 2050) and live and draw income in retirement for another 40 years (expected life expectancy of a little more than 100 years…a conservative assumption but you never know).
Now that we are done with taking inventory of what they own and where, the next step is to project the future based on how much this couple has now, the portfolio size they need to retire on as well as the income that can be reasonably derived during retirement to make sure that they don’t run out of money before they run out of time. The first set of projections assume no additional contributions to their portfolio and a portfolio growth rate of 8% (why 8%, more on that later) during their working years and a growth rate of 5% during retirement or decumulation years. Once retired, this couple will need an entire year’s worth of income on the first day of each year in retirement. That means that instead of drawing income through the year, they expect to have a lump-sum amount at the start of each year in retirement.
But how much should they draw from their portfolio? The answer you probably have heard often is that if they can withdraw close to 4% of the value of their portfolio each year, the money technically should last their life time. But is that a fact? And what life expectancy estimate is that based on? With people on average living well into their late 70’s, there is no reason that someone in his 30’s today should not plan to live till he or she is 100 or so years old. And hence, they have to plan their income needs for that far into retirement. With that as a backdrop, this family’s wealth trajectory is likely going to reflect the plot below assuming that they don’t make any new contributions from this point forward. The vertical dashed line highlights the year of retirement along with an estimate of the accumulated wealth right before retirement. If they don’t take any distributions (highly unlikely in their case but there are situations where that might be true) and assuming that their portfolio grows at the rate of 5% during retirement, they will end up with a pretty sizable sum as shown by the terminal value of the blue curve below.
But if they withdraw at a rate equivalent to 4% of the value of their portfolio each year (that is what most folks use), this family will still end up with some money left over shown by the terminal value of the pink curve below. The present value of that final wealth number post income draw during retirement is about $100,182. Not great but at least there is something.
But there is a problem and a few questions to ponder. Is the income derived by withdrawing 4% a year from their portfolio enough for this family to live on? And will the purchasing power of that income grow over time to match or exceed the rate of inflation? This family’s income in the first year of retirement will be $54,761 as shown by the value at the start of the bluish-green curve below. That income represents $19,461 in today’s purchasing power as shown by the value at the start of the orange curve. That for sure is nowhere close to what this family would need to live on but let’s just go with that number. But the purchasing power of even that number declines with time, shown by the orange curve (decline in real income).
So they would have to dip into the principal to supplement their income and maintain their purchasing power. That is shown by the revised bluish-green curve where they start out drawing the same income in the first year of their retirement as before but then the income requirement just starts exploding (the bad side of compounding).
In the final year of their retirement, they have to draw $173,428 to afford the same amount of stuff they did when they retired. But as expected, they will run out of money way before that due to principal erosion as shown by the yellow curve in the plot below. This couple has choices though; save and invest more money each year or delay the year they expect to retire or live on a tighter budget in retirement by drawing a smaller percent from their assets each year. There is a fourth option and that is to invest aggressively during retirement but then one can never predict the sequence of expected market returns so it’s best not to count on it.
So clearly that 4% rule of thumb is just that, a rule of thumb. But what if they wanted to live with reasonable comfort in retirement, drawing $50,000 in today’s dollars each year. Inflation adjusting that to the year they expect to retire means they will need $136,595 in the first year and growing with inflation during their retirement as shown in the plot below. If that is their income need and based on how their portfolio mix has performed in the past, they will need to save an additional $16,029 each year while they are working. Reasonable proposition? Maybe, maybe not.
But all of that with no legacy left behind i.e., nothing for their kids to inherit as shown by the terminal value of the yellow curve in the plot below.
If leaving some kind of a legacy is important to them and if they could save about $20,000 (includes their retirement plan contributions) each year, they will be able to leave behind $4,655,934 for their heirs to inherit (shown by the terminal value of the yellow curve below) while drawing $50,000 in today’s dollars each year during retirement. The present value of that amount is about $507,242. Pretty reasonable but it’s for this family to decide.
The last two plots are derived by first calculating the portfolio value required right before retirement to enable this family to draw $50,000 in inflation-adjusted income during retirement. The portfolio value is then discounted to today’s dollars to come up with the additional savings required each year. PV is the present value, i is the inflation rate, r is the portfolio growth rate and C is the cash flow or income needed during retirement.
We have made all these assumptions and projections about what this hypothetical portfolio is likely going to do in the wealth accumulation and decumulation phase of this family’s life but what is the basis of using 8% and 5% for each of these phases? For the portfolio they own, its compound annual return since 1987 has been 9.45%. 1987 is the first year when data on some of the investments they own became available but market returns in general have not swayed too far from that number going back about a century. But of course, there is no guarantee of what the future holds but if the overall capital markets don’t do well, no other investment will. So considering this historical precedence and the fact that this portfolio will include more fixed-income and alternative investments at some point in time, the 8% return assumption is not completely out of line. The plot below also shows that there have been extended periods where this portfolio’s performance basically sucked and that is completely normal. Periods when the portfolio under-performs is the best time to accelerate deploying more savings into investments because these marginal periods are usually associated with attractive valuations that will likely revert at some point in time. But no one knows and can predict when that will happen so as long-term investors, they have no choice but to stick to their plan and remain invested.
A few more things on the plot below…the returns shown are rolling returns. Three year returns mean 1987-1990, 1988-1991, 1989-1992 and so on. Same for 5, 10, 15 and 20 years. A point to note is that there has never been a 10, 15 or 20-year period where this portfolio lost money as long as they remained invested.
So there you have it. A simple yet practical financial plan that anyone can interpret and implement. Need yours done…let us know…for a limited time only :).
Image credit – Ken Teegardin, Flickr