One Minute Drill for Retirement Planning

Kurt Brouwer July 19th, 2007

“Are Your Finances Ready for Retirement” is an interesting article in WSJ Online by Glenn Ruffenach and Kelly Greene on retirement planning. The article is adapted from their book, The Wall Street Journal Guide to Retirement (Three Rivers Press/Crown Publishers, 2007). In the piece, they go through a couple of methods of figuring out how much money you will need in retirement.

The authors walk through two methods of doing this. The short version, which they call the One Minute Drill comes from a tax attorney:

‘…One-Minute Drill

This method, developed by Charles J. Farrell, a tax attorney in Denver, is based on the idea of replacement ratios. First, to calculate your annual budget, multiply your current gross income by the replacement ratio of 0.8. This means we’re estimating that you will need a “salary” in retirement that amounts to 80% of your pre-retirement income. Then, to calculate the size of the nest egg needed in later life, multiply your current gross income by 12.

Let’s see what this math would look like for a couple — we’ll call them Andrea and Scott — who are a year or two away from retirement and are making about $80,000 (combined) a year: Multiplying that income by 0.8 shows they will need $64,000 a year in retirement. Multiplying $80,000 by 12 shows they will need a nest egg of $960,000.

It’s important to note that we start with a big assumption: that the average American can, in fact, live comfortably on 80% of his or her pre-retirement income in retirement itself. While the rule of thumb has long been that most of us will need about 70% to 80% of our pre-retirement earnings once we leave work, this assumes that about 20% to 30% of our money while we’re working goes to things like taxes, transportation and savings and that all those bills will drop off in retirement…’

At first glance, I thought this method violated the 5% rule of thumb, which theorizes that you can spend approximately 5% of your portfolio (assuming reasonable investment returns and asset allocation) per year after retirement without dipping substantially into your principal. But as I read further, I realized they were not doing so, at least in this example:

 

‘…So, let’s return to our couple — Andrea and Scott — who are making $80,000 a year before retiring. If they have managed to build a nest egg totaling $960,000, a 5% withdrawal yields $48,000. Add to that figure a minimum of $16,000 that our retirees will collect each year from Social Security (that’s a rough calculation from the Social Security Administration) and — voila! — you get $64,000, or 80% of pre-retirement income…’

In this case, they actually are sticking to the 5% rule of portfolio withdrawals and supplementing that with Social Security in order to get to the annual ’salary’ needed. Now, in this formula, they are using pre-tax income required. I think it is better to look at expenses after income taxes, but that’s a quibble.

It’s a good piece. Read the whole thing. I’ll look at the second method they review in another post.

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