[Retire Early]
The Big Question: How much do I need to retire on?

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The Big Question: How much do I need to retire on?


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This page was last updated on February 1, 1999.

Most of the research suggests that an individual withdrawing 4% to 5% of assets annually is probably pretty safe. This means you'll need about $200,000 to $250,000 in capital for every $10,000 in annual pre-tax retirement income required. It also means that a million dollars isn't what it used to be. A $1 million dollar nest egg will only support a $35,000 to $50,000 per year lifestyle, depending on how much risk you're willing to accept. This fact drives home the importance of working on the living expense side of the equation.

How do I calculate how much I need?

First, determine your pay out period. That's the length of time you need your retirement nest egg to last. What's your life expectancy? You can find out by consulting the IRS Life Expectancy Table. To be safe, you may want to add 5 or 10 years to your life expectancy to come up with your pay out period. If your grandparents lived to be 100 and you're in excellent health you may even want to add even more.

Once you know your pay out period, you can calculate the inflation adjusted withdrawal rate. (See, "What's the safe withdrawal rate in retirement?") You need to think about how much risk you are willing to take. (See, "The Retire Early Study on Safe Withdrawal Rates.") The higher the risk, the greater the chance you'll suffer an involutary return to the work force. Run some scenarios for yourself using the Retire Early Safe Withdrawal Calculator. This Excel spreadsheet uses 127 years of stock market data (1871-1998) to illustrate the range of returns for various pay out periods. The results are shown in Table 1., below.

Having your inflation adjusted withdrawal rate in hand, simply divide your annual income requirements by the withdrawal rate. For instance, for someone with a 4% withdrawal rate and $25,000 per year in expenses:

Annual Expenses $ / Safe Withdraw Rate % = Capital Req'd

$25,000 / 0.04 = $625,000

In addition to inflation adjusted "safe" withdrawal rates, the table below shows the optimal mix of stocks, bonds, and cash for each pay out period.

Table 1. - Annual Withdrawals vs. Age
- --- Asset Allocation ---
Age IRS
Life
Expectancy
(Yrs.)
Pay Out
Period
(Yrs.)
Withdrawal
Rate
(% of assets)
Optimal
Percent
Stock
Capital Req'd
per $10,000
Withdrawal
Stocks
(%)
Bonds
(%)
Cash
(%)
----------100% Safe Withdrawal Rate -------------------
40 42.5 50 3.37% 82% $296,736 82% 14% 4%
50 33.1 40 3.54% 77% $282,486 77% 19% 4%
60 24.2 30 3.81% 71% $262,467 71% 25% 4%
70 16.0 20 4.75% 66% $210,526 66% 29% 5%
80 9.5 20 4.75% 66% $210,526 66% 29% 5%
90 5.0 10 7.56% 44% $132,275 44% 48% 8%
---------- 95% Safe Withdrawal Rate -------------------
40 42.5 50 4.28% 82% $233,645 82% 14% 4%
50 33.1 40 4.44% 77% $225,225 77% 19% 4%
60 24.2 30 4.45% 71% $224,719 71% 25% 4%
70 16.0 20 5.26% 66% $190,114 66% 29% 5%
80 9.5 20 5.26% 66% $190,114 66% 29% 5%
90 5.0 10 8.12% 44% $123,153 44% 48% 8%
---------- 90% Safe Withdrawal Rate -------------------
40 42.5 50 4.56% 82% $219,298 82% 13% 5%
50 33.1 40 4.82% 77% $207,469 77% 18% 5%
60 24.2 30 4.95% 71% $202,020 71% 24% 5%
70 16.0 20 5.63% 66% $177,620 66% 28% 6%
80 9.5 20 5.63% 66% $177,620 66% 28% 6%
90 5.0 10 8.65% 44% $115,607 44% 47% 9%

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Looking at "safe" withdrawal rates of 3% to 5% causes some folks to ask, "if the stock market returns over 10% per year, why can't I withdraw something close to that in retirement?" Unfortunately, the stock market doesn't go up 10% every year. It goes down too, sometimes for prolonged periods. Low "safe" withdrawal rates are the cost of protecting your retirement nest egg against this volatility. Fidelity's Peter Lynch wrote a good article on the subject some time ago, click here to see it.

How should I invest my retirement nest egg?

It's easy. (1) Put an amount equal to one year's expenses in a money market fund. (2) From the asset allocation table above, put the optimal percentage in stocks. The most convenient and least expensive way to invest would be through one of the several available low fee mutual funds.(See, "Should I invest in mutual funds or individual stocks and bonds?") (3) Put the balance into a laddered portfolio of 2 to 5 year US Treasury notes or FDIC insured bank certificates of deposit (CDs). (See, "Are CDs a good substitute for US Treasury securities?")

For a 40 year pay out period and $10,000 per year income, the breakdown looks like this assuming a 4% annual withdrawal. (I know, nobody can live on $10,000 a year. Just ratio up to what you feel you need.)

(Data as of 12/31/98 WSJ)
Investment
-----------------------
.
Amount
----($)----
.
Yield
---(%)---
Annual
Income
----($)----
Exp.
Ratio
---(%)---
Annual
Expenses
----($)----
Sales
Load
---(%)---
Sales
Load
----($)----
Money market fund
Vanguard - Prime Portfolio
.
$10,000
.
5.38%
.
$538
.
0.32%
.
$32
.
None
.
$0
Bonds
Treasury Direct - 2 to 5 yr Notes
.
$47,000
.
4.75%
.
$2,233
.
None
.
$0
.
None
.
$0
Stocks
Vanguard - S&P500 Index Fund
.
$193,000
.
1.17%
.
$2,258
.
0.19%
.
$367
.
None
.
$0
. _______ . _______ . _______ . _______
Total Capital = $250,000 . $5,029 . $399 . $0

Frequently Asked Questions. (FAQ's)

Question 1.

Q....You show only $5,029 per year in annual income in the example above. Where does the other $4,971 needed to equal $10,000 per year come from?

A....You need to sell some stock (S&P500 index fund) each year to bring your annual withdrawal to $10,000.

Question 2.

Q....How can there be zero expenses in your Treasury Direct account? There is no free lunch.

A....One of the best deals in the investment world is that small investors can buy Treasury securities directly from the Federal Reserve, pay no commission, and get a higher interest rate than 50% of the big money Wall Street firms buying the same security. You accomplish this by entering a "non-competitive" bid at the next Treasury auction.

For more on how Treasury auctions work and how you can set up a Treasury Direct account by mail and have the interest payments on the securities depositied directly into your checking account, click here.

Note: There are often times that CDs have a higher yield than Treasury securities. (See, "Are CDs a good substitute for US Treasury Securities?") You should compare the yields on both before investing.

Question 3.

Q....How is it possible that you have expenses of only $399 per year for a $250,000 portfolio? I just set up a similar investment portfolio with my broker and will pay over $2,500 in expenses the first year.

A....Only $2,500? It could be worse. Wrap accounts at full-service brokerage firms run as high as 3% of assets per annum. That's $7,500 the first year. Even a more cost effective fee arrangement is still pretty bruising. For example, the same type of portfolio with Merrill Lynch would look like this (Note: Merrill Lynch is used as an example here, but the results would be similar with Paine Webber, Smith Barney, or any other full service brokerage firm):

.

(Data as of 12/31/98 WSJ)
Investment
-----------------------
.
Amount
----($)----
.
Yield
---(%)---
Annual
Income
----($)----
Exp.
Ratio
---(%)---
Annual
Expenses
----($)----
Sales
Load
---(%)---
Sales
Load
----($)----
Money market fund
Merrill Lynch - Ready Assets
.
$10,000
.
5.12%
.
$512
.
0.50%
.
$50
.
None
.
$0
Bonds
Merrill Lynch - Federal Securities D
.
$47,000
.
5.10%
.
$2,397
.
0.90%
.
$423
.
4.00%
.
$1,880
Stocks
Merrill Lynch - S&P500 Index A
.
$193,000
.
1.05%
.
$2,027
.
0.40%
.
$772
.
None
.
$0
. _______ . _______ . _______ . _______
Total Capital = $250,000 . $4,936 . $1,245 . $1,880

This isn't even the worst case portfolio as far as fees and commissions go. But any full service broker would charge fees and sales loads totaling many times the $399 in our low fee portfolio.

It's important to note that in the example illustrated above the sales load and annual expenses totaled more than 60% of the first year's investment income (Expenses = $1,245 + $1,880 = $3,125, Income = $4,936). Three thousand dollars would easily pay for the annual lease on a nice car. Something to think about when dealing with a full service broker.

Question 4.

Q....Shouldn't you deduct the sales load from from the amount invested? My broker routinely does this. For example, in Question 2 above, the $47,000 you invested in the Merrill Lynch Federal Securities D fund would leave you with only $45,120 in the account after paying the 4.00% sales load. This would also reduce the annual income from $2,397 per year to $2,301 per year.

A....You are absolutely correct. Since our Merrill Lynch example was so unfavorable, I was trying to be charitable in not calling attention to the fact that the sales load comes off the top and into the broker's pocket before any money is invested on the customer's behalf. Yet another reason the be wary of high fees and commissions.


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Copyright 1999 John P. Greaney, All rights reserved.

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