Start by estimating how much before-tax income you will need from your savings in the first year of retirement. This should be in the dollars of that first year, and not in today's dollars. If you estimate that you'll need $100,000, that is approximately $55,000 in today's dollars assuming a 3% per year inflation rate and 20-year time period until retirement. Divide the $100,000 by 4%, which is the same as multiplying it by 25. Your answer will be $2.5 million. It's shocking, but you have to remember that under our assumptions about inflation, that it is equivalent to $1.4 million in today's dollars.
It can be shown mathematically that if you have a $2.5-million nest egg, and you can earn a 4% real (ie, inflation adjusted) return on your portfolio every year during retirement, you will be able to withdraw an inflation-adjusted income of $100,000 per year no matter how long you live. And at the end of every year and at the time of your death, your portfolio will still have an inflationadjusted value of $2.5 million. So you will never have to worry about running out of money. A real annual income of $100,000 means you can withdraw $100,000 in the first year, $103,000 in the second year (if the rate of inflation is 3% for that year), and so on.
Expend Your Savings
What if you are willing to expend your savings by the time of your death? Won't that reduce the size of the necessary nest egg? Yes it will, but not by as much as you may think. If you retire at age 60 and expect to live until age 95, the difference will be small. The $2.5- million estimate leaves a reasonable margin of safety during your retirement years for unexpected circumstances. Plan to maintain this margin of safety.
The amount the projected number will decreaseâ€”if you plan to deplete your savings by the time of deathâ€”can be determined by using a slightly more sophisticated calculation that you can not do on the back of an envelope. Generally, the fewer the number of years you plan for retirement (ie, by retiring later), the smaller your nest egg will need to be if you are planning to exhaust it.
Predict Your Real Return
You may be wondering why 4% was used in your initial calculation. It's a reasonable estimate of the real return you may be able to earn on your portfolio during retirement. If you assume inflation will average 3% per year, then this is equivalent to assuming a nominal portfolio return of 7% per year. Considering that you should hold a mix of stocks and bonds during retirement, and assuming that bonds will most likely provide lower returns, a total return of 4% is a reasonable expectation.
If you think you will be able to earn 5% instead of 4% real return per year, you should divide the $100,000 by 5%, or multiply it by 20, to get a lower solution of $2 million. This is, of course, a big difference. Assuming that you will earn a return greater than 5% is not realistic, especially since there are many other uncertainties you are not accounting for in this analysis.
When you get closer to retirement, you may want to obtain a more sophisticated estimate that incorporates more accurate assumptions of taxes and earnings. However, because retirement planning involves predictions about the future, more numbers do not necessarily mean better estimates or shed more light on the problem. As Nils Bohr said, "Prediction is very difficult, especially if it's about the future."
Chandan Sengupta, author of The Only
Proven Road to Investment Success (John
Wiley; 2001) and Financial Modeling Using
Excel and VBA (John Wiley; 2004), currently
teaches finance at the Fordham University
Graduate School of Business and consults with individuals
on financial planning and investment management. He welcomes
questions or comments at firstname.lastname@example.org.