Retirement Capital: How Much is Enough?
By Jeff Bernier
A few years back, a large financial services firm ran a television advertisement with people walking around with a number in a cartoon balloon over their head. The size of the number varied from individual to individual. The voice over on the advertisement asked the question, “What’s your number?” Viewers were to glean that the number was how much capital each person needed to accumulate to fund his or her retirement. The premise being that everyone has “a number” and that you need to know your “number” like you need to know your anniversary date or Social Security number. (And, if you buy their annuities, mutual funds, and life insurance, they can get you to your “number”.)
Many years ago, I saw a dynamic speaker at a conference by the name of Dewitt Jones, a photographer for National Geographic magazine. In his presentation, he showed incredible pictures of places and people he had encountered from around the word. These pictures were BREATHTAKING! What was even more interesting though, was after he showed you an extraordinary photo, he would then show you another of the same landscape, person, etc. But this time, with a different angle, lighting, perspective, or equipment. While I was amazed at the first photo, the second was even more amazing. The theme for his presentation: More Than One Right Answer.
By stressing that you must know your “number”, that financial services commercial was essentially narrowing complex goals, dreams, aspirations, and life choices, to a simple mathematical calculation. I refute that you have just "one number”. Like Dewitt Jones, I believe that there may be more than one right answer.
I do not want to be too hard on the financial services firm that produced the advertisement. Encouraging people to plan for their future is certainly a good thing. Most people would benefit from a detailed wealth accumulation plan with specific goals and dates. A good plan will translate dreams into specific goals with dollars and deadlines. However, a quality advisor should be hired not to just solve for “your number”. Simple online tools can do this although often with questionable assumptions. A quality advisor should be helpful in crafting a holistic wealth plan that takes into account your dreams, specific goals, and all of your resources while coaching you on the tradeoffs. I heard a leader of a large planning firm state that he believed that advisers are not hired to make a financial plan – they should be there to change the plan – as life happens.
A “Simple” Retirement Capital Calculation
While there is no "one number”, you can make an educated guess of the amount of capital required, based on academic research regarding “safe withdrawal rates” and a few simple assumptions. I will offer this simple method with the caveat that this is only a general guideline and is no substitute for in-depth analysis that takes into account all of your resources (both financial and non-financial), risk preferences, health, makeup of accounts, taxes, etc.
- If you were retired today, how much would you expect your annual expenses would be (include living expenses, annual healthcare cost, travel, entertainment, charitable gifts, etc.)? Let’s assume $100,000 per year.
- Since we asked for expenses, we need to gross this up for income taxes. We will assume an average combined federal and state income tax liability of 20% (this is likely to be conservative – with good planning around tax distribution, this number could potentially be lower). Therefore, we will assume a pre-tax income goal of $125,000 which would result in after-tax income of $100,000.
- Since these numbers are in “today’s dollars”, we need to inflate this by an expected inflation rate from now until retirement. We will use, 2.25% and 10 years until retirement. With a $125,000 spending goal and a 2.25% inflation rate, in 10 years you will need $156,000 to live like you live today on $125,000 in pre-tax income.
- From the $156,000, you would subtract your future direct income such as pensions, income annuities, or social security. We will assume no pensions or annuities and combined Social Security for both spouses of $45,000 leaving a $111,000 shortfall that would need to be covered by distributions from capital.
- In a future post, I will discuss an appropriate “safe withdrawal rate”. For now, we will just use a 4% withdrawal rate from capital. Using a 4% withdrawal rate and assuming withdrawals would increase annually at the rate of inflation for 30 years, you could simply multiply the shortfall by 25 to get the amount of capital needed at retirement. In this case $111,000 x 25 = $ 2,775,000.
- In this example, we assumed retirement was 10 years away. You would, therefore, take your current portfolio, add future annual contributions, and compound the results at a reasonable expected return based on your investment temperament (typically around 4% - 7%) over the next 10 years to determine if you were “on track”.
If you are retiring today, you would use the $125,000 pre-tax income goal for your pre-tax spending today. Reduce it by your direct income (pension, social security, etc.), $45,000 in my example, and get you to an amount required from your capital of $80,000. Again, assuming a 4% inflation-adjusted distribution rate for 30 years, multiply $80,000 by 25 to get to your number of $2,000,000.
If the numbers above give you “sticker shock”, this is where a personalized plan can be valuable. The 4% “safe withdrawal rate” was defined in the research as the maximum distribution if you needed the portfolio to last 30 years and retired at the worst possible time. It is likely and possible that your "safe withdrawal rate" could be much higher (reducing the capital required), or it could be lower (increasing the need for capital). There is a lot of recent research questioning whether the 4% “rule” should be much lower given expected capital market returns. There are others who suggest that it is still appropriate as expected inflation is lower and past research did not take into account using a more diversified approach with higher expected return asset classes (small-cap stocks, emerging markets, etc.). You will want to discuss these issues with your advisor.
Your plan could also be designed where you “front loaded” expenses on things like travel when you are healthy and assume you will spend less in the future. Your spending will be higher in some years and lower in others for things like replacing a car or unexpected health care expenses. In addition, the sequence of investment returns and timing of withdrawals can greatly impact your plan as well. A simple one number calculation will not take this into account.
The plan could assume that you sell your home and move into a smaller, less expensive home or that you eliminate a mortgage. It could potentially model strategies like a home equity conversion mortgage (HECM) that could reduce mortgage expense or create income from the equity in your home. Creating additional sources of income through part-time work or consulting can also have a significant impact on what your “number” might really be. Again, a simple one number calculation would not take this into account.
Failing to Plan is Planning to Fail
With so many variables and unknowns, the idea of planning for retirement can seem overwhelming. We believe clarity and confidence can be enhanced by having a professionally constructed, holistic wealth management plan and a trusted advisor to guide you along your journey. One important part of this engagement should be to determine if you are on track to meet your retirement income needs and, if not, how to navigate the choices to get on track. Additionally, every financial plan should be open-ended so that throughout the planning process you and your advisor are making corrections as life circumstances, expectations, outcomes, and goals change. At TandemGrowth, our coaching process is designed to help you address your concerns, uncover opportunities, and leverage your strengths. We believe your plan should be as unique as you are.