Kurt Brouwer September 26th, 2007
Over the years, I have spoken with many people about their retirement plans. I suspect that I have heard all of the normal questions and concerns. First and foremost is:
“Will we have enough money to last our lifetimes?”
I don’t think I have to spell out the implications of running out of money when you’re old and gray, because your imagination can do that for you. However, there is good news. Due to the many public and private programs to help people with their basic needs, it is very unlikely you will starve or be without food, clothing, shelter and medical care, no matter how long you live or no matter how much or how little you have saved.
However, I suspect most of us want a bit more during our post-retirement span of years than living on public aid or private charity. We want to continue our lives, help our families, enjoy some comforts and live a good life. Perhaps our definition of the good life might be a bit more than that envisioned by the Beatles, but their tune, “When I’m Sixty Four” still applies today, although with increasing life expectancy we would probably have to make that 74 today.
When I’m Sixty Four
When I get older losing my hair,
Many years from now.
Will you still be sending me a valentine
Birthday greetings bottle of wine…
This song was my mother’s favorite Beatles’ tune. She used to sing a verse or two and ask me if I would still love her at 64. She’s 86 now and I still love her very much, so I can safely say we have answered that question. But, plenty of questions remain, chief among them is what retirement looks like to you and how much spending is enough. The song’s view of retirement happiness was pretty simple:
…I could be handy, mending a fuse
When your lights have gone.
You can knit a sweater by the fireside
Sunday mornings go for a ride,
Doing the garden, digging the weeds,
Who could ask for more.
Will you still need me, will you still feed me,
When I’m sixty-four.
Every summer we can rent a cottage,
In the Isle of Wight, if it’s not too dear
We shall scrimp and save
Grandchildren on your knee
Vera ,Chuck & Dave…
Though it was a tongue-in-cheek rendition of a middle class lifestyle, there is much to recommend in the sentiments of the song. For example, we want our lives to have meaning beyond our working days. We want to be productive. We also want to be part of something bigger than ourselves, whether that is our faith, or our families or our friends and neighbors. So, to broaden the question a bit, we need to ask: “Will there be enough to enable us to live the way we want to live once we’re retired?”
How Much Is Enough?
In other words, you need to define what “enough” means for you. I frequently say to clients who are concerned about retirement that you can have any thing you want, but not every thing you want. Though a bit simplistic, the point is clear–you have to make choices because your resources are limited. Here is one way to answer the question of how much is enough.
“Are Your Finances Ready for Retirement” is an interesting article on 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…’
So, by this formulation, to determine what you will spend after retirement, you just calculate 80% of your current pre-tax income and assume that this is what you will spend in retirement. That amount would come from Social Security and pension income, if any, supplemented by investment income and any post-retirement employment income. Finally, in order to determine if you meet this test, you would multiply your income before retirement by a factor of 12 to determine what size portfolio you would need to produce the level of post-retirement income you want. In this case listed above, $80,000 times 12 equals a portfolio of $960,000. This could be made up of after-tax investments, retirement assets such as IRA rollovers and other investment assets such as real estate.
A Few Quibbles…There are several assumptons that factor into this formula. To start, it assumes you do not want to ever spend any of your principal or capital. That may be the case, but for many people this is not the case. For them, the 5% rule really understates what they could safely spend. One other flaw in this formula is that it works pretty well for those with incomes of $100,000 or less, but it does not work as well for higher income households. This is because Social Security benefits are capped, so they benefit higher income households much less than lower income households on a percentage basis.
The 80% rule also does not account for those who can reduce expenses significantly after retirement. For example, many retirees still have a mortgage that is only a few years away from being paid off. When that is paid off, their expenses will go down permanently. In other cases, people are helping children with college expenses and, at some point, that expense will end. The formula also fails to account for those who move from a high cost state to a lower cost state after retirement. In those cases, the 80% formula for calculating expenses is too high. It is also too high for high income households. Once you get over $250,000 a year or so, the formula is probably closer to 60%.
But, these are quibbles. I like this formula because it is pretty easy to calculate. It may not–and almost certainly will not–fit your situation perfectly, but it is a useful exercise. In my experience, people generally need pre-tax income of 60%-80% of their pre-retirement income and this article spells out an easy way to figure out that number for your situation. It also then helps you determine how much you need in your portfolio to cover your post-retirement spending for your lifetime.
Toughing It Out in a Tough Market Fund owners with long investment horizons have a big advantage at the moment. It’s a simple point — but one often that is ignored when markets are volatile.