Funding Retirement
Let’s face it: the end game of our working lives is funding a viable and comfortable retirement. Sure, some of us revere the daily work load while others cannot wait to slide down the dinosaur’s back at 5:01. Hopefully, after 30 or 40 years, we’re ready to count our chips and spend the next few decades slowly cashing them in. Each household needs are different as well as the dynamic demands within the family. Personally, mine are that of a Franciscan church mouse while Michelle & her tabby are Kardashian-esque {Brief sidebar: I am truly amazed that a stray cat has developed an exclusive taste for Ahi tuna and Boar’s Head turkey}. Having accepted delayed golden years, let’s discuss the delicate relationship between retirement savings and a sustainable withdrawal rate.
RAM
Obviously, a retirement portfolio is likely to last longer with a lower withdrawal rate. But there are a few other components to ensure portfolio survival. What is a realistic income need? A baseline is the retiree’s final annual salary – say, $100,000. Next, let’s consider the retirement account balance - $600,000. If you divide the retirement account by the annual salary – you’ll arrive at the Retirement Account Multiple[i] (RAM) – for this example it would be 6. Now let’s say the retiree wants to withdrawal 5% year. Multiply the RAM by the proposed withdrawal rate (6 x 5) and you arrive at the income replacement percentage (30%). Finally, multiplying the income replacement % x final salary (.3 x 100,000=$30,000). This number roughly becomes the income needs for the retirement portfolio without touching principal. We’re in wonk paradise now.
For those still reading, the above exercise is a starting point for realistic withdrawal parameters and how the portfolio should be designed. In other words, how much should be invested in bonds, stocks, and cash. The higher the RAM and lower the income replacement need – the portfolio can be more conservative. The lower the RAM and higher the income replacement need – the account will be under more stress and hence the need for more aggressive investments. Also, this plays into the likelihood of lifetime portfolio survival or, more simply, not outliving one’s money.
Realistic Withdrawal Rates
None of the above considers inflation, IRA RMD’s, taxes & other sources of retirement income. Nor do we think it’s realistic for most to delve deeply into the referenced calculations. But what can be useful is understanding the RAM and what a realistic withdrawal rate is. The long standing rule of thumb has been 4%. We feel that could be up for debate in today’s zero interest rate environment. Whereas the risk-free rate on a 10 year treasury has been historically well over 6%, it is now 1.75%. For the conservative retiree, this may depress the annual withdrawal rate to the 2-3% range. For example: a 65 year old couple with a RAM of 8 and initial withdrawal rate of 6% has a 34% chance of 35 year portfolio survival with a 25% stock/75% bond allocation. But if you bump the allocation to 65%/35%, the chances of survival rise to 87%.[ii]
Financial longevity is a primary investor worry. But this worry can be mitigated by saving diligently and prudent spending. Yes, there are many unknowns - future variables that you can only guestimate. There isn’t financial planning software available that can forecast 35 year inflation rates, tax rates, health, unforeseen emergencies/large expenditures, investment returns, changing risk preferences & household budgets. My yellow fin and high heel budget in 35 years? I’ll just be happy to be around to find out.
[i] Israelsen, “A Magical Formula”, Financial Planning, April 2015
[ii] Athavale, “A Safer Withdrawal Rate Using Various Return Distributions”, Journal of Financial Planning, July 2011