*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:

- Investment Planning: The Series
- Household Budgeting the Easy Way
- Budget Tracking and Projections (with Quicken Tricks)
- Willingness, Ability, and Need
- Estimating a Retirement Budget
- Need for Risk: The Details [this post]
- Multi-Period Planning and Asset Allocation
- Investment Planning: Reader Tips, Tricks, and Links

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.