Steve TeSelle, CFA, CFP ™
September 2000
Many of us are working hard to save for retirement, yet we don’t have a great sense of what the target is. That’s right, you’re not alone. A key reason for the confusion is that we’re not entirely clear about the assumptions that create the target: How much income will we need? What level of returns can we expect from our savings? How long will our savings last? Also, the definition of retirement is changing as people live longer. Some of us may continue to work or earn income well past the arbitrary age of 65. And finally, how should we treat assets like our homes and projected Social Security benefits?
My goal here is to give you a framework to help you get a handle on retirement. Generally, you want to:
Estimate your annual expenses
Calculate a lump sum that will generate the income you need, and
Translate the lump sum into future dollars and calculate the amount you need to add to your retirement savings each year to get you there
To get a handle on an approximate goal for your retirement, the first step is to get a rough idea of your annual income need during retirement. You probably wouldn’t be too far off to start with your current budget. The budget should be adjusted lower if you expect to have paid off a mortgage by the time you retire; it should be adjusted higher for travel, if you plan to help your children or grandchildren, for health costs, or if you just want a bit of a cushion. The Social Security web site suggests that retirees’ budgets average 70% of their pre-retirement budget. I’m the kind who likes a cushion, so my estimate is that our retirement budget will be about the same as our current budget.
Current retirees spend more in the earlier retirement years,
as they travel and eat out more often. In later years, spending drops as people
stay closer to home. You might assume a higher budget for the first ten to fifteen
years of retirement, and then, say, a 15-20% reduction afterward. 
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There’s a rough calculation for what you need annually. This is in today’s dollars. Now we move on to how much you have to have saved in order to meet this annual spending need.
As a general rule, you should draw down on your retirement savings at an initial rate between 3% and 5%. Yes, you read that right. It’s probably lower than you had expected. But remember, inflation nibbles away like a church mouse, year after year. If you estimate inflation at 3%, and your net returns are around 6-8% (due to a more conservative asset mix and to taxes), withdrawals above 3-5% will reduce principal. The more principal you eat into in those early years, the faster you’ll run out of savings.
Researchers have looked at how long a 50% stock/50% bond portfolio would have lasted in the past with various initial withdrawal rates (Journal of Financial Planning, April 2000). At 3%, the portfolio lasts indefinitely through both good and bad market environments; at 5%, the portfolio lasts as few as 20 years. Obviously, if you have a lot in stocks, and there’s a tremendous bull market for two decades, you can afford a higher initial withdrawal rate. My preference is not to hope for the great bull market of our dreams, but to plan for the future based on some reasonable assumptions.
If you knew exactly when you would die, the withdrawal calculation would be tricky enough, but who knows when he’s going to die? Not me. Given my grandparents’ longevity, I’m likely to be pestering people for quite a while. Rather than count on government mortality tables, I’ll count on living well into my 90s. So if I plan to retire when I’m 50, my savings has to last half a century.
I won’t spend much time on asset allocation; that’s for another extremely insightful and thoroughly absorbing piece that I’ll write soon. For now, my message is that the retirement portfolio must allocate a high enough percentage to equities so that the portfolio has the chance to grow faster than inflation. Stocks bear the risk of a loss; bonds and cash bear the risk of you outliving your savings.
Now divide your annual income need by your initial withdrawal rate (say, $70,000 by 4%, which equals $1,750,000) and you get the lump sum that you need to live that happy retirement life, the one in which you don’t have to subsist on canned beans and box wine. The number we have right now is in today’s dollars, meaning that if you want to know how much you’ll need in twenty years, you adjust for inflation (multiply by 1 plus the inflation rate to the 20th power). But let’s keep it in today’s dollars for a minute so you can deduct from our lump sum figure anything you’ve already saved (401k or IRA, for example). [Revision 10/11/01: Rather than deduct savings in current dollars, you should allow savings to grow at a rate you set, and then deduct this amount from your future lump sum amount. This allows you to account for savings growing faster than inflation. The formulas in the spreadsheet are set up in this manner.] Also, if you’re one of those fortunate few who has a pension, you can take the present value of the pension and deduct from the lump sum; or take the annual pension amount and deduct it from your annual income need before you divide by the withdrawal rate. (Caution: If the pension doesn’t rise with inflation, use the present value method.) This is also the step where you can deduct Social Security payments from your annual income need.
How much you rely on Social Security to fund your retirement depends on your age. The younger you are, the less clear it is what Social Security will look like by the time you retire. Retirement ages and benefit calculations for the program could change significantly over the next twenty or thirty years. I doubt the entire Social Security Fund will evaporate, but benefits could become means-tested, for example, which translates into lower benefits for those who have saved. You should have received a notice from the Social Security Administration regarding the benefit you’ve earned so far, which is probably a fine figure to plug into your calculations. Like company pensions today, no one is likely to take away benefits you’ve already earned. If you’d like to estimate future benefits, you can go to www.sss.gov and calculate to your heart’s content.
I should say a word or two about the homestead. For many people, the home is one of the largest assets. Should you include it in your retirement savings calculations? It depends (don’t you hate that?). You need to live somewhere in your retirement. Maybe if you’re going to move to a smaller, less expensive home, you could count on some of the sales proceeds for retirement. Currently, the first $500,000 from the sale of a home is free of taxes (married, filing jointly). Also, there are reverse mortgages and home equity loans that allow you to take equity out of your home while you continue to live in it. But reverse mortgages are still new, so you have to be sure to understand the costs and conditions; and you might not want the risk of running out of money to repay a loan and being forced to move. You might also want to leave your home to your children or to a charity as part of an estate plan. In my own retirement calculations, I do not include my home.
Since company pensions are becoming scarcer than a brief speech
at a convention, and since I’m not counting on much from Social Security (and
yes, not making any deductions makes my little example easier), I won’t make
any reductions to my lump sum figure ($1.75M). Now I’ll take it forward twenty
years at an inflation rate of 3% (I have confidence in the Federal Reserve to
avoid a re-run of the 1970s and early 1980s), and we get just over $3M in 2020
dollars. That’s my target if I want to retire in twenty years. [top]
Let’s confront taxes before we get to the savings plan. The easiest way to deal with taxes in all this is to use pre-tax figures. When you estimate your retirement income need, you start from your current budget; so use your salary rather than your after-tax income. Retirement income from 401k plans, traditional IRAs, and pensions is taxed at ordinary income rates, which is similar to getting a salary and paying taxes on it. Even Social Security payments are taxed if your income is high enough.
You may have some tax-free savings, such as a Roth IRA. While
this is a good thing, it complicates the calculations a bit. I think the best
approach is to divide what you have in a Roth IRA by .7 or .8 (1 minus your
tax rate) to make the amount a pre-tax figure. Then subtract this pre-tax figure
from your lump sum retirement amount to get how much you still need to save.
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Now we can put together a spreadsheet with some reasonable
assumptions about expected returns, and voila, we have a target both for the
total retirement amount, and for an annual savings figure. Continuing my example,
to get to just over $3M in twenty years with no other retirement savings, I
would need to save just over $55,000 per year and earn 10% a year on the assets.
That number might give you an ulcer; but wait, time can help. If you have thirty
years, you need to save $26,000 a year; and only $13,000 a year if you have
forty years. Time, like your dog, can be your friend.
Remember, these are just estimates. The future will undoubtedly differ. For example, the average return to equities since 1926 is around 10%, but returns have varied widely over the years. We could have an extended period where the returns are below 10%. Nor do we know what the tax environment will look like. We could return to a 70% marginal tax rate with loads of loopholes, as we had in the late 1960s. Also, your estimate of your annual living expenses at retirement may change. Maybe health care costs will become the single biggest budget item for retirees. We don’t know how the future will be different from our expectations (master of the obvious). But if we review where we are every so often, and adjust our assumptions over time, we can make a reasonable plan that adapts to changes.
The advantage of engaging in this little exercise is to get a handle on some realistic expectations for your retirement. If you want to retire in five years and spend lots of time traveling, you have $100,000 saved currently, you’re adding $5,000 a year, and you expect your retirement to last 30 years, you’ll have to rethink your plan. The success of that plan is about as likely as sitting on your own lap.
The disadvantage of retirement planning is that you might look at the numbers and decide the situation is as hopeless as the current PGA tour for everyone but Tiger Woods. But if you fall in this category, don’t despair. Just start saving what you can and check every once in a while to see where you stand. Saving is like doing homework - once you get started it’s not so bad.
If you would like me to e-mail a spreadsheet that will help
you get started, let me know. I think it’s straightforward, but then I created
it. If the spreadsheet makes as much sense to you as a Chemistry text does to
me, give me a call and ask me to explain. You can also go to the following web
sites for more information and for easy-to-use calculators:
If you’re one who likes thinking about this stuff as much as kicking yourself in the shins, I’m happy to do the spreadsheet dirty work. Give me a call and we can talk about my fee and what’s involved.
Please feel free to contact me about retirement concerns and
questions, or anything else, by phone at (303) 733-4999 or e-mail at steselle@doratocapital.com.
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