The two questions I received most frequently, after people found out I was retiring, were “What are you going to do with yourself?” and “How did you decide you had enough money to retire?” The former question is essentially the focus of this blog in general, but in today’s post I will specifically address the latter.
There is a trade-off in selecting a retirement date. The earlier you retire, the more time you have to pursue interests outside your working career, and the more items you can knock off your “bucket list”. The later you retire, the greater your financial security. There is risk both in retiring too early (running out of money) or too late (running out of good health). It is difficult to strike the right balance, but approaching the problem in an analytical fashion can help a great deal.
The classic answer to the question of “How much money do you need to retire?” is provided by William P. Bengen in “Determining Withdrawal Rates Using Historical Data”, in the Journal of Financial Planning, October 1994. This beautifully written paper clearly explains the principal factors affecting how long a portfolio lasts. The conclusion might be paraphrased as follows: You are unlikely to run out of money in 30 years, if you withdraw, from stock-heavy investment funds, 4% in your first year of retirement, and amounts increased for inflation in subsequent years. The figure below, from Bengen’s paper, shows how well such a strategy would have worked historically (the answer: very well).
Many people have reanalyzed this question since this paper was published, and some have suggested slightly lower or higher percentage values, but the 4% rule remains the standard guideline. So suppose you have all your money invested, will receive constant income, and expect a fixed annual budget for the rest of your life (except for inflation adjustment). Then the amount you need to retire is 25 times the difference between your budget and your income. For example, if your expenses including taxes will be $70K in your first year of retirement, and you’ll have social security income of $30K, then you need 25 x (70 – 30) = one million dollars to retire.
We use a somewhat more sophisticated approach, though it agrees pretty well with the 4% rule once we account for the complexities of having both expenses and income that will change over time. Our financial advisors run Monte Carlo simulations that, through a thousand or so random numerical trials, determine the probability of still having money left at death. Experts recommend that this “probability of success” should fall between 75% and 90%. Lower numbers involve higher financial risk, while higher numbers can cause you to miss out on accumulating great life experiences. We chose 85%, giving us only a 15% chance of running out of money before dying, in the absence of corrective action.
With the classic 4% rule, even if you get ahead because of a favorable stock market, you do not change your spending, because the excess is needed for statistical security. This conservative approach does make sense, but I think it is even better to make some adjustments in spending depending on how the investment portfolio is doing. The primary reason for doing this is that, on average, if you choose a fairly high probability of success, you’ll still have quite a bit of money left at death. For example, the figure below shows representative results from Monte Carlo simulations. The horizontal axis is age. Green curves correspond to “successes”, where there is still some money left at death; red curves are failures. The median result is that you die with about twice as much money as you had when you retired! That is a lot of money to leave unspent in an average outcome.
Our plan is to reevaluate the probability of success at the end of each year, and determine how far ahead or behind we are relative to the 85% point. If we are ahead, we’ll consider one-half of the excess to be available to spend. If we are behind, we will reduce planned international travel to compensate, as this is the easiest part of our budget to trim back.
The last piece of our financial strategy relates to taxes. Although the performance of the stock market cannot be reliably predicted, taxes are largely deterministic. Consequently, it is possible to formulate a fairly rigorous tax plan, and it can have a significant impact on money available in retirement. Our goal is to avoid paying over 15% federal income tax at any time in retirement. This can be a challenge after age 70.5 because of required minimum distributions from traditional IRAs, plus social security income. A lot of older retirees are now finding themselves in unfavorable tax brackets.
Late each year we plan to add up our income, and calculate how much more income we could have while remaining in the 15% tax bracket. After leaving a little margin for error, we will then take a distribution of that amount from a traditional IRA, and roll it over into a Roth IRA. In this way, we’ll only pay 15% tax at the time, and no tax later. By age 70.5, we will have substantially reduced the size of our required minimum distributions, and hopefully will keep out of the 25% tax bracket.
In summary, a reasonable guideline is that before retiring, you should have savings that are about 25x what you will need annually to pay expenses and taxes, beyond what is covered by any income you have, such as social security. More precise planning can be done with Monte Carlo software used by financial advisors. In addition, careful thought should be given to a tax strategy to avoid having some years, especially after age 70.5, in which you end up in a higher tax bracket than necessary, because you have not fully exhausted a lower tax bracket in previous years.
Nomadic Naturalists 