The primary shortcoming to retirement planning is that the investor must make predictions – inflation and the cost of living, health care costs, tax rates, investment portfolio returns, life expectancy, etc. Successful retirement planning is predicated on accurately estimating three components:
- How much money will you spend (and by extension, the amount you must withdraw from your nest egg).
- How long do you expect to make withdrawals (your life expectancy minus your retirement age).
- How much money (if any) do you hope to bequeath to heirs, charities, etc.
Example: An investor wants to retire in seven years, at age 62. He will be eligible to receive $19,152 in Social Security each year, has no pension and expects no earned income in retirement.
Step 1: His current expenses (food, clothing, home expenses, leisure activities and health care) total $51,000 per year. By age 62 the home will be paid off, but he expects his health care and leisure activities expenses to rise. After some financial planning and budgeting homework that includes the effects of inflation, he estimates an annual living expense of $55,000 for the first year of retirement – age 62. He will receive $19,152 in Social Security, and therefore must withdraw $35,848 per year from his investment portfolio beginning at age 62.
Step 2: For how many years must he make withdrawals? This is an important factor. A 68-year-old retiree can safely withdraw a higher percentage of their nest egg than one who retires at 55. Many advisors, myself included, have determined that an investor can withdraw 4 percent per year from their portfolio, and that portfolio can still achieve 3 percent annual growth in value to offer inflation protection; (this calculation assumes a balanced investment portfolio will earn an average annual return of 7 percent, which historically has been achievable, but of course is not guaranteed). A person retiring at age 68 will have far fewer years of withdrawals, and the impact of inflation is diminished, therefore a 5 percent annual withdrawal rate may be acceptable. In this example the investor is retiring young, and a maximum 4 percent withdrawal is recommended.
Step 3: At death, what does he want to bequeath (if anything) to heirs, charities, etc.? A retiree may want to completely preserve their wealth through retirement, or may be comfortable spending-down their portfolio over the years. In the first assumption – wealth preservation – multiply the required withdrawal of $35,848 by 25 to get the required investment portfolio. In this case a nest egg of $896,200 is sufficient. In the second assumption – spending down your portfolio – assume a 5 percent withdrawal, so multiply $35,848 by 20 to get a required nest egg of $716,960.
At this point the investor then turns their attention to saving and investing with a goal of hitting the “required” nest egg value. This method is basic, but a good starting point to retirement planning.