• This post has been cited in the Carnival of Personal Finance #219, hosted by Your Money Relationships.

This is the sixth in a series of posts on investment planning. For those who haven’t read the first post (or have forgotten), I’m soliciting feedback (tips, tricks, links, etc.) that I will cite and use in the final post of the series. Here’s a list of the other posts in the series:

This post builds on prior ones in the series and I assume the reader has read them. So far I’ve covered the development of a current household budget, discussed how to use it for tracking and projections, related the surplus it indicates to ability for risk, and used it to estimate a retirement budget. The retirement budget indicates how much investment income (which includes the possibility of spending principal) one expects to need in retirement (in current dollars). What will be the source of this investment income?

The source I will focus on is a portfolio of securities, or what I will call a retirement nest egg. Other sources include various types of annuities, which I will not discuss. To keep things simple, let’s assume you expect to live for up to 30 years in retirement and you do not wish to leave funds to your heirs. In this case, how big a nest egg do you need to generate a specific level of income?

A key concept is the notion of a safe withdrawal rate (SWR): the inflation adjusted percentage of your nest egg value (at time of retirement) you can withdraw annually with very small risk of out-living your money. In the now classic “Trinity study,” Cooley Hubbard, and Walz found, based on back-testing, that a 3% SWR was safe for a wide range of asset allocations.

By definition of SWR,

[Eqn. 1] investment income = SWR x (initial nest egg),

where “investment income” is in constant dollars. Thus the initial nest egg (at time of retirement) must be

[Eqn. 2] initial nest egg = (investment income) / SWR

for a given investment income.

In the example of the previous post (see spreadsheet), an investment income of \$1,567 per month or \$18,804 per year was required. Using Eqn. 2 and an SWR of 3%, this translates into an initial nest egg of \$626,800 in current dollars.

We have now established the necessary inputs for designing a retirement investment plan: ability to invest (the surplus of the current household budget), dollar goal (initial nest egg), and time span (between now and date of retirement). What return on investment is required to satisfy these constraints? This classic finance problem is easily solved using a financial calculator, spreadsheet, or any number of online savings calculators.

Let’s solve the specific problem implied in this spreadsheet and referenced above. Assume the budgets in the spreadsheet are for an investor age 35 years wishing retire at 65, a 30 year span. He needs to build a \$626,800 nest egg and has \$725 (his budget surplus) to invest per month (assuming he’s investing nothing via a payroll deduction). Using, the Bankrate.com savings calculator iteratively, we find that he will need an annual return of 5.4% to reach his goal. This is the real rate of return required. The nominal rate required will be this rate plus the inflation rate. Assuming inflation of around 3%, a rate of 5.4% + 3% = 8.4% will be required.

The investor will need to inflate his monthly investment as well: \$725 is the real amount. This reflects the virtue of budget tracking. By tracking one’s budget, one can periodically reassesses one’s needs and income as they grow with inflation and be sure one’s surplus is growing at a sufficient rate.

Is the 5.4% real rate determined above reasonable to expect? If the hypothetical investor of the example thinks not then he should go back to his budget and see if he can find ways to scrape together some additional funds to invest and re-compute the necessary rate of return. What’s a reasonable maximum real rate of return? Real rates of return are expected by Rick Ferri and William Bernstein to be no higher than 7%, depending on asset class. So 5.4% does seem like a reasonable goal.

Once one has determined the necessary rate of return, the next step is to develop a plan to achieve it. That’s the topic of the next post in the series.

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• All this sounds reasonable but (and it is a ver big but) there are two main issues with these calculations:

1. taxes – achieving an average real return of 5.4% before taxes is realistic with good asset management and a focus on keeping costs down. Whether this can be achieved after taxes is another matter entirely

2. SWR – safe withdrawal rates are highly senstive to below average or negative retruns in the early years. Have a few bad years at the outset of retirement and you will run out of money a lot quicker than you planned

Cheers
traineeinvestor

• @traneeinvestor – Fair points. But what should one do about them? My suggestions are: Invest in tax-advantaged accounts. Be mindful of taxes and seek the return that achieves your goals in light of them. I implicitly dodged the tax issue by basing one’s retirement income on one’s current income after taxes. A safer approach is to put taxes back into the budget and to save enough to pay for those as well. This is a good idea and I’ll point it out in the final post.

My other suggestion is to continually monitor your status with respect to your goals and adjust your pre- and post-retirement plan accordingly; If adjustment in SWR is required in light of performance then that is what must be done. However, the Trinity study to which I referred was based on back testing that included up and down years. 3% was found to be safe over a 30 year period in a wide variety of asset allocations, with the exception of 100% bonds. Not safe enough? Reduce it to 2.5% or 2%.

• As to the tax question – it is something of a non issue for me given HK’s relatively benvolent tax regime 🙂 – but anything that can be tax sheltered should be tax sheltered. That said, given current excess spending at federal, state and city level it seems inevitable that tax rates will rise and/or deductions and shelters will be eroded. My retirement budget assumes HK tax rates will rise 2%.

As to the SWR – there are two ways to address this. The first is the one you have suggested of lowering the SWR. The longer the retirement period the lower the SWR. The study you cite uses 30 year periods. I intend to retire at 46-48. Given that my wife is younger than me and comes from a family with long life expectancies, I am planning on the basis that our savings will have to last 50 years. For that length of time, I am uncomfortable with any draw down of principal. The second way of dealing with the issue is to continue working after the target is reached for 1-2 years.