Last weekâ€™s article, â€œHow Much Will You Need?â€ omitted one important detail: how much will you need to accumulate in savings to maintain the lifestyle youâ€™ve enjoyed while working and collecting a paycheck? In this column, Iâ€™ll attempt to offer some formulas to answer that important question.
First, the longer you will continue working before forgoing those regular paychecks means that your calculations regarding what youâ€™ll need for retirement will be less reliable than for those who are now closer to retirement. If you still have at least 20 years to work, the assumptions made now may well generate inaccurate estimates for your savings goal that are, possibly, well off the mark. But since we must begin somewhere, annual assessments of todayâ€™s assumptions will allow for corrections or adjustments to keep you on a plan with a reasonable chance of success.
The first assumption we need to establish is what your standard of living will cost in that future first year of idleness. The best place to start is with how much you spend annually now — while working. No, itâ€™s not a perfect place to begin, but it may be as good as any other.
If you and your family now spend, on average, $3,000/monthly for living expenses, assume that you will need that much in retirement, too. Sure, your circumstances will change. For example, the kids will be grown and on their own, and isnâ€™t that a nice thought? So your food and energy costs will decrease. Obviously, education costs will go away, as will other associated costs of child rearing.
The possibility exists that, by then, you will have paid off your home mortgage, so those costs may be eliminated. So far, this looks like youâ€™ll have some extra cash on hand. Good for you, if thatâ€™s the case!
But offsetting those decreasing expenses will be other costs not incurred now. One of the biggest will involve filling your time. What would you do today with the time you spend working and getting to and from work? If you plan to spend most of your time on the sofa, watching Oprah and eating bon-bons, no problem! But most retirees, hopefully, have better ideas.
While your retired friends are playing more golf, going out to dinner often or traveling frequently, they may invite you to go along from time to time. And you probably have your own interests regarding hobbies and travel. Hereâ€™s a quick exercise that can generate some thinking in this planning. On a clean sheet of paper, make a weekly activity schedule as though next Monday began your first day among the leisure set. What will you do each morning, afternoon and evening to fill that time?
Hereâ€™s another exercise that can help with your planning. Find friends or relatives who are already retired and ask how much their spending changed in the first years of retirement. If they are like most retired people I know, they will tell you that they still spend the same amount as they did while working. And many will mention that needs for medical attention and associated health care expenses seem to rise each year.
Of course, help will be available from government programs like Social Security and Medicare. And some of you may be lucky enough to have earned monthly pension payments. So, be sure to include those in your estimates for income and outlays.
Next, letâ€™s assume that you will need that same $3,000 from your savings each month to augment your other sources of income. And weâ€™ll add on the income that you do not enjoy while working, like those Social Security and pension payments, to cancel out any new spending needed to fill your free time. Those other sources of income will also help offset taxes incurred if youâ€™re taking money from tax-deferred savings accounts like IRAs. Donâ€™t forget taxes!
Now you have an initial estimate for retirement needs. So letâ€™s figure how much savings you will need to accumulate to generate that monthly paycheck of $3,000. One rule of thumb estimates (and is as good as any other in this field of uncertainty) that you can safely use up to 5% of your savings in the first year of retirement without undue concern of spending too much of your savings, too quickly.
Taking 5% of the total amount you have saved means that your remaining savings will need to generate a 5% return in that first year to maintain your available assets. Should your investments suffer a bad year and your savings fail to generate the needed 5% return, you may suffer damage that cannot be recouped in the following year.
Of course, a nasty fall in your account value could throw the whole plan into disarray, but proper allocation of investments can limit downside risk. And thatâ€™s yet another reason why I advise the use of â€hedgingâ€ strategies, but thatâ€™s another topic for another time.
But letâ€™s assume that your savings enjoys at least moderate growth each year and does not suffer a large drawdown in any one year while you are removing money. So if you need $3,000/monthly for living expenses, you will withdraw $36,000 in the first year. And if that represents 5% of your savings, multiply $36,000 by 20, with the result of $720,000. That is how much you will need to have saved to begin that monthly withdrawal schedule.
Another major consideration is recalculating, in the second year of retirement, your future needs. Of course, with inflation now running hot and perhaps getting hotter, as future liabilities owned by our government in those same social programs that should benefit you, the potential for huge increases in the money supply are assumptions I would include in my estimations. With this in mind, assume that you will need to increase your monthly withdrawals by about 5%/year. So recalculating your plan for the second year of retirement shows you will now need savings of $3,150/month, times 12 months, times 20 years. This plan requires a savings goal of $756,000.
Do you see a potential problem? By my estimates, you need to have earned a 10% return on your savings in that first year of retirement to not only fund your monthly withdrawals but to ensure sufficient growth to cover inflationary effects on future spending.
At the start of your third year of retirement, you would need to grow your savings to almost $800,000. So growth of about $40,000 on top of withdrawals of $38,000 means you require annual growth close to 10%/year, ongoing.
Whatâ€™s difficult is that, in the real world, an average annual return of 10% or thereabouts means investing in a riskier fashion than most retirees find comfortable. Such returns like those over sustained periods are almost impossible to achieve, even in the best of times. Adding to this problem is that you should keep a portion of your savings in stable assets like cash, money markets and higher-yielding securities like bonds, if philosophical guidelines allow. So you may find yourself in the situation where about 70% of your portfolio needs to generate the entire 10%/year gain, which is a mean feat, indeed!
So, what is the plan now? First, I think that a higher-risk profile for a retired investor is not a bad thing. Keeping large portions of your savings in equities still makes sense. But investing according to a strict value-oriented mandate is essential, of course.
Hereâ€™s what I suggest, and this involves another exercise. Make three circles on a sheet of paper, each representing a pot of money. In the first circle, put a number that closely estimates your cash needs during your first three years of retirement. In the second circle, recalculate your estimate to include the effects of inflation. In the third circle, write the number reflecting what remains of your savings, or one as close as you can estimate it.
For someone thinking he will need $3,000/month in the first year of retirement, calculating for 5% inflation during the first three years will assume withdrawals averaging $3,165/month. That amount multiplied by 36 months gives a result of $115,000. In the second circle, you should allocate $135,000 to furnish average monthly payments of $3,750 for three years assuming the same rate of inflation annually. That amount should allow for a greater exposure to higher yielding stocks in the third pot of money, assuming $470,000 is left to invest.
In the first circle, your pot of money, including cash and money market accounts, should yield about 3%/annually. In the second pot, moderately risky investments like bond funds could yield 5%/annually. For the third pot, we will assume 7%/annual growth. Hopefully, youâ€™ll do better, but letâ€™s play it safe for now.
Assuming that all goes according to plan, your first yearâ€™s growth would add up to about $43,000. If you took $36,000 in the first year, the plan doesnâ€™t look so bad, eh? But there would not be sufficient growth allowing for annual raises of 5% to match assumed inflation rates. So consider a slower rate of withdrawal to add comfort and the ability to increase your withdrawal schedule in later years to keep pace with inflation and unexpected expenses.
Two possible improvements on the 5% withdrawal in the first year plan would involve assuming that you will take 5% in the first year, but only from savings in the third, more risky pot. Or might a first-year 4% withdrawal schedule from all savings be a better way to go?
If you take less than planned in the first year, based on investment returns, you can always adjust in ensuing years and take more. But if your third pot suffers a bad year, donâ€™t worry too much, since that money still has another five years to recover.
This plan is not perfect. Much will change over the next few years, and I am assuming in my own calculations higher rates of inflation than 5%. But you need to start estimating your needs versus availability now, and this is the best method I know of.
Have a great week. Bob
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., firstname.lastname@example.org.