Robert is currently earning a salary of $60,000 a year. With his kids preparing to head off to college, Robert is suddenly aware that he is getting older and needs to address his own future needs. Although he’s never formally learned about the four elements of a financial goal, he’s already got one set: Robert would prefer not to work a day beyond his 65th birthday. He’d like to retire in 20 years (Element One). All the other steps are designed to figure out how or if he can make this wish a reality.
In order to fill in the blanks of all four elements, Robert will next proceed to get a rough idea of what kind of return rate (Element Two) he will aim to get from the investments he will make over the 20 years.
Robert has $50,000 already saved, but he is largely depending on his salary to make his investments and cannot afford to take the higher risks associated with an aggressive portfolio. So, given that he also scored a 12 on the Risk Quiz (risk steady but close to the opportunistic investor category), he’s looking to build a moderate portfolio that could give him an average annual return rate of 8 percent. So he’s got his Element Two— an 8 percent annual expected rate of return—which we’ll put aside for a bit while we calculate the mechanics of his saving plan.
When looking ahead to retirement and how much will be needed (Element Three—the lump-sum goal) to live on, you need to use a combination of imagination and common sense. Will your mortgage be paid off? Will you travel more or less? Traditional financial planning suggests you need less to live on in your retirement. I disagree. Modern medicine has tremendously improved the quality of our later years. Some of the seniors I know are going to law school, solo sailing to Bermuda, or treating their children and grandchildren to a family get-together hiking the Alps. Even if you aren’t planning an extravagant retirement, it’s safe to assume you will need at least as much money to live on in retirement as you have now.
In Robert’s case, I might take his current salary and use that as the base. But inflation will reduce the amount that $60,000 will buy in 20 years. To retain the same purchasing power, it’s best to factor in inflation.
How much inflation? We don’t know what the next 20 years will bring, but 3 percent is a good assumption to use. So, factoring in inflation, Robert will need $109,000 a year once he retires ($60,000 × 3% compounded over 20 years).
Once we have the annual retirement income target, we need to figure out what other income streams besides investments will be available to fund the goal. In Robert’s case, he’s expecting to receive $40,000 annually from a pension and $32,000 from Social Security. That leaves $37,000 annually that he’ll need to come up with every year from his investments (see Table 3.1). This amount is important, but it’s not the same as Element Four, Robert’s lump-sum retirement goal. We’ll need to do a little more work to get that.
Figuring out exactly the size of the lump sum needed in retirement isn’t easy. You quickly bump up against the grisly conundrum of retirement planning: None of us knows how long we’re going to live. If you don’t know how long you will live, how do you decide how much you need to live on— your ultimate target? How many years will Robert need that $109,000 annual retirement income? In essence you need to back out the final number by using a few simple calculations.
How long your money lasts depends on two variables: the return rate you can get and your withdrawal rate. If you know what kind of portfolio you’re going to allocate your money to, you can get some sense of the return rate you can expect. But you can’t be certain. In addition, depending on how successful you are at building your nest egg and how much money you’ll need in retirement, ratcheting down your withdrawal rate is a choice you can make, but it isn’t always a realistic option.
What do I recommend in an ideal world? On this score I’m a dyedin- the-wool conservative. I like to help my clients save and invest enough money to build a nest egg that will allow them to withdraw an amount they can live on comfortably without ever touching or depleting the principal.
As for the kind of return rate I project my clients will get over the long haul, I generally assume 5 to 6 percent a year. But as you can see in Table 3.2 (How Long Will Your Money Last?), a change in either the return rate or the withdrawal rate affects your nest egg’s life span. For example, if your money is returning 6 percent and you spent 10 percent of it annually, the nest egg will last 16 years.
But if your money gets a return of 6 percent and you spend only 6 percent annually, it could hypothetically last forever. As a basic rule of thumb, your withdrawal rate must be equal to or below your expected return rate if you don’t want to draw down your nest egg and wind up jeopardizing the financial stability of your later retirement years.
To figure out your lump-sum goal, start with 6 percent as your hypothetical withdrawal rate. In my 35 years of experience I’ve found 6 percent to be a conservative and reliable rate, though some people prefer to be more aggressive and others prefer to be more conservative. Just divide the amount you’ll need every year by 6 percent.
Read More : Walking through a Retirement Goal
