Retirement Planning Rules of Thumb are Likely Off-Target

retirementnumbersWhat’s your “Number”? You know, that elusive amount of investment assets you need when you stop working so that you don’t run out of money in retirement.

Barron’s ran a series of articles Saturday on retirement which included rules of thumb for calculating your number. “Conventional wisdom” would have you take 75% of your annual working income, subtract your social security and pensions expected in retirement and then multiply the result by 25 to get “your number.”

Here’s a simple example. Household income of $120,000. Social security expected to be $30,000, no pension. 75% of income is $90,000. Subtract $30,000. The result is $60,000. Multiply by 25 and the number today is $1,500,000. It will keep increasing with inflation. Easy calculation. But likely off-target. Here’s why:

First, using 75% of your current income as your expense level for all of retirement could be way off. You may have mortgage payments that will exist for only a few more years into retirement. You might still have children at home at retirement time for which education costs will be incurred. And, at some point, the kids might leave home and reduce your expenses. You might currently only be spending half your paycheck and investing the rest. For business owners and salesman, expenses in retirement could be higher because previously company-provided benefits now have to be paid personally.

Also, expenses in retirement change over the years. Typically spending declines when folks reach their late 70s or early 80s. And, then with medical costs, expenses could ramp up significantly if people live into their 90s. Furthermore, a married couple will likely not die on the same day, particularly if there is an age difference. Expenses of one person for part of the retirement period will typically be less than expenses for two people.

Second, the use of multiplier of 25 is based on a “safe withdrawal rate” of 4% each year. The concept is that since expenses will increase with inflation, if the portfolio earns 7% and you withdraw 4% the first year, then your principal grows 3% which means you can draw 3% more in year two (due to inflation) without breaking the bank. Furthermore, this 4% number is an after-tax amount. So, for example, if the funds you accumulate are all traditional 401(k)/IRA funds, then every retirement withdrawal will be subject to income tax. If we assume a 25% income tax rate, your withdrawal rate just went down to 3% and your multiplier just went up to 33.33.

Third, you may have other assets that should be included, for example if you have equity in your house. At some point, your house could be sold, downsized or you could consider a reverse mortgage. In each cases, these funds would reduce your “number”.

Here’s a better way to do retirement planning:

  1. Instead of using income, use your actual expenses as a starting point. On the first day of retirement, what will your expenses likely be? If some expenses will drop off in a few years, put those in a separate column. If you have wants and wishes in retirement, for example travel or a second house, show those separately for each item, number of years of payments, etc.
  2. Using actuarial tables modified by family and personal longevity likelihood, calculate the number of years you (and your spouse) will likely live.
  3. Identify before retirement what your annual additions to your investment portfolio will likely be and separate it between qualified plans and taxable amounts.
  4. Review your risk profile and determine your likely asset allocation while you are working and after retirement.
  5. Prepare a year by year analysis of your financial retirement plan, while you are working and during retirement. For each year, this will show the beginning investment portfolio, investment additions, post retirement income, investment earnings, income taxes, expenses during retirement and ending portfolio value. And, of course, inflation needs to be incorporated into the calculation as well.
  6. Then use a Monte Carlo or similar simulation. It incorporates all of your data in a random order to account for the uncertainty and performance variation and produces thousands of scenarios of possible outcomes. The result- the likelihood of “success”, i.e. having enough money for your lifetime.
  7. Stress test your plan for such items as early death or disability, social security being reduced or eliminated, long-term care costs, etc.
  8. Regularly (at least annually) review the above assumptions and see if you are still on plan or if revisions are necessary.

I’m sure that the above seems overwhelming. It doesn’t need to be. There is good software available to help in the calculation and illustration of the above. We use MoneyGuidePro and, of course, we expedite the process of our clients. If you’re not working with us, you might attempt to do this calculation on your own.

It will take more time than the simple calculation that some use to find their “number.” However, it certainly will provide a more accurate target for you for the future and give you greater peace of mind about your finances. After four decades of doing this for clients, I can assure you that the process is well worth the investment.