Is AARP Correct?

According to an article published by AARP, almost half of Americans fear running out of money in retirement.[1] A challenging part for people entering retirement is to determine how much income is needed to last a lifetime. You don’t want to run out of money at 83 if you’re going to live to age 90.  If you’re worried about running out of money in retirement, you probably don’t have a financial plan. A financial plan will help you answer several questions about your future, including how much is enough. Worrying is also a lack of faith.

I’m often asked, “How much income will I need?” and “How long will it last?” The first question is easier to answer than the second. You’ll need, at a minimum, enough income to cover your annual expenses. The amount of income you’ll need in retirement will be driven, in large part, by your expenses.

Your expenses probably won’t change dramatically in retirement. The dollar amount may stay the same, but the categories will change. For example, rather than spending money for college, you’ll allocate it to travel.

The best way to budget for your retirement expenses is to review where you’ve spent your money. What financial footprints have you left behind?  A deep dive into your spending habits from the past two to three years will help you paint a picture of where your future expenses may land. By identifying how you’ve spent your money, it will be easier for you to adjust your future spending.  

After your review, can you find expenses to prune or eliminate?  By reducing your expenses, you’ll be in a better position to save for retirement. I also suggest increasing your spending budget by 5% or 10% to give yourself a little wiggle room before you enter retirement due to unexpected expenses.

As you get closer to retirement, I recommend reviewing your budget every quarter to get a better handle on your spending habits.  It’s not uncommon to see a spike in spending before retirement as a result of several factors like buying a new car or remodeling your kitchen.   

It’s prudent to add a black swan, or random event, category to your budget as there’s always an unforeseen spending expense during the year like a car repair, home repair, or medical expense. A suggested amount for this category is 5% of your total budget.    

In retirement, housing will account for most of your annual expenses. According to the Consumer Expenditure Survey[2] from 2014 to 2015, housing accounted for 32% of a person’s budget for those 65 and older. Transportation came in second at 15.6%, healthcare was third at 12.5%, and food items were fourth at 11.9%.  Housing is a considerable expense in retirement, even if you don’t have a mortgage. Utilities, property taxes, and repairs are fixed costs that will always attack your budget. 

Let’s review the original question, “How much money do you need for a comfortable retirement?”  If your annual expenses are $100,000, you’ll need more than this amount to cover your expenses.  Your income can come from several sources like investments, pensions, Social Security, or property rentals.

To generate $100,000 in income, you may need $2,500,000 in assets. How did I arrive at $2,500,000?  The magic number in this equation is 4%. To get $2,500,000, divide your expenses by 4% ($100,000 divided by 4% = $2,500,000).  You can also multiply $100,000 by 25, the inverse of 4%, to get the same result. Why 4%? A former Registered Investment Advisor, Bill Bengen,[3] created the 4% rule. I won’t go into his analysis, but he found that if you withdraw 4% of your assets every year, you shouldn’t run out of money.

Let’s look at a few examples. Again, assume your annual expenses are $100,000. At $100,000, you’ll need an investment portfolio of $2,500,000 earning 4% ($2,500,000 x 4% = $100,000).   This calculation assumes you’re only spending income, and you’re not invading your principal.   

By adding Social Security to your equation, the amount of assets needed in retirement will drop.  If your Social Security income is $30,000 per year, deduct this figure from $100,000 to get $70,000.  $70,000 is what you’ll need to generate from your investments.  Applying the 4% rule gives you $1,750,000 ($70,000 divided by 4%). 

If you have a company pension, your need to generate income from your investment portfolio falls further. Let’s say your annual pension is $20,000. This reduces your income number to $50,000 after subtracting Social Security and your pension ($100,000 - $30,000 - $20,000 = $50,000). The assets needed are $1,250,000 ($50,000 divided by 4%).  

As you can see, the more passive income you receive, the fewer assets required. We started with an individual with no passive income requiring assets of $2,500,000 to generate $100,000 in annual income. The retiree who receives a pension and Social Security was able to lower their asset level to $1,250,000 to receive the same level of income.

The “three-minute financial plan” can calculate the amount of assets you’ll need for retirement. You can compare it to your current level of assets to see if you have enough money to retire. If you have enough assets to cover your expenses, you can retire at any time - on your terms.

The math will help answer the second question, “How long will my money last?” If you’re withdrawing less than your accounts are earning, you should never run out of money. An account earning 5%, withdrawing 4%, will grow at 1%.

If you withdraw more money than your account can generate, you run the risk of running out of money. For example, if you retire with $500,000 and your withdrawing 10% a year ($50,000) from an account earning 5%, your retirement nest egg will only last 15 years.

Let’s pay another visit to the three-minute financial plan. I’ve included a table to help you calculate the level of assets you may need to cover your expenses. A 40-year-old with $50,000 in annual expenses will need $2.3 million at retirement. An inflation rate of 2.5% will increase her annual expenses from $50,000 to $92,697 at age 65. Applying the 4% rule to her inflation-adjusted expense number (divide by 4% or multiply by 25) will give her $2.3 million ($92,697 x 25).  

You can identify your asset level from the table below. Use the inflation factor nearest your age to calculate the future value of your expenses. Once you have this number, multiply it by 25 to give you your asset level needed in retirement. 

This model will also tell you the growth rate needed to achieve your goal. Let’s say you’ve saved $200,000 by age 40, and you’re contributing $19,000 (the maximum allowed) to your company retirement plan.  We know your asset goal is $2.3 million based on the math in the chart, so an annual rate of 7.02% for 25 years is needed to reach your asset goal.    

If you’re able to save an additional $6,000 (the catchup provision) per year, the rate of return needed is 6.17%. The rate of return number dropped because you’re saving more money. The more you can save, the less your account will need to earn.  

The three-minute financial plan will tell you quickly if you’re on track to meet your retirement needs – or not.  This plan can help you set the framework necessary to reach your goal.  A long-term rate of 7.14% is aggressive, so you’ll need to own more stocks than bonds. An appropriate asset allocation for this growth rate suggests a portfolio of 75% stocks, 25% bonds.  

Let’s change the parameters and look at a 55-year-old who wants to retire in 10 years. She has $100,000 in annual expenses and $2,000,000 in savings. Her expenses in 10 years will be $128,008. The asset level she’ll need is $3,200,211 ($128,008 x 25).  She’ll have to earn 4.08% to reach her goal - a conservative rate so that she can own more bonds than stocks. An allocation of 75% bonds, 25% stocks would be appropriate for her portfolio. 

How much is enough, and how long will it last? As you read, you can answer these questions with a few inputs on a calculator or Excel spreadsheet. Once you know the answer to these questions, you can adjust accordingly. The three-minute financial plan is your quick guide to getting your retirement on track.  

“Therefore, I tell you, do not worry about your life, what you will eat or drink; or about your body, what you will wear. Is not life more than food, and the body more than clothes? Look at the birds of the air; they do not sow or reap or store away in barns, and yet your heavenly Father feeds them. Are you not much more valuable than they? Can any one of you by worrying add a single hour to your life?” ~ Matthew 6:25-27

December 3, 2019

Bill Parrott, CFP®, CKA®, is the President and CEO of Parrott Wealth Management located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM’s custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on the level of your assets.

Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren’t suitable for every investor.