How much do you need for retirement?
We should all be so lucky as to retire someday. As noted in Morgan Housel’s new book, The Psychology of Money, retirement didn’t really become a thing until after World War 2. Before that, people worked until they couldn’t work anymore. In fact, the 401(k) isn’t even 40 years old. The 401(k) started in 1981 and now have a total estimated value of over $6 trillion. made that happen and now we have a whole industry dedicated to helping people retire with dignity.
I am one of those helpers; a key function of our service to clients is retirement planning.
And one big question around retirement planning is: how much do I need to save?
Now, retirement doesn’t always mean that you stop working. To me, retirement is synonymous with independence or freedom. If you have a retirement plan, save, and invest diligently, retirement becomes the point at which you have enough money to dictate whether you want to stop working.
So, assuming that we’ll all ‘retire’, are you prepared? It is an incredibly important question to answer. How much we accumulate before the salary turns off will determine how well we live in our golden years.
A quick disclaimer: The following exercise is for illustration purposes only. The illustration provides point in time estimates rather than a range of outcomes. Life and retirement planning are never perfect. So, please remember that retirement planning is an intensely personal effort and many of my assumptions may work in general but may not apply to you.
Ultimately, retirement planning comes down to longevity. We do not know the answer to, nor can we know when retirement ends. Retirement planners use probability tables, which are based on population statistics, but these are guesses and not concrete answers. For the sake of argument (and simplicity!), I assume retirement will last 30 years.
Here’s what longevity looks like for a retired couple, both aged 65, non-smokers, and in good health.
American Academy of Actuaries and Society of Actuaries, Actuaries Longevity Illustrator, http://www.longevityillustrator.org/, (accessed October 16, 2020).
While a 30-year retirement is a reasonable estimation, it may also leave you exposed to the risk of outliving your money. The 65-year-old couple has a 1 out of 3 chance of living past a 30-year retirement expectation. This is called longevity risk, and not captured in this analysis. Nevertheless, it remains a crucial point for all retirement planners.
Due to longevity risk, retirement doesn’t have definite answers. And like anything without a definitive answer, there are competing ideologies on the optimal way to start a retirement portfolio. Two primary options are SAFEMAX and Liability Matching.
SAFEMAX seeks to determine safe withdrawal rates. The safe withdrawal rate is the percent of your starting retirement portfolio that you can take out each year and not run out of money over a 30-year horizon. The starting amount grows by inflation each year too. This study was conducted by William Bengen and uses historical market data to calculate SAFEMAX. Bengen wrote an excellent book titled Conserving Client Portfolios During Retirement to present his results. The book shows that a portfolio of 40% Large US Stocks, 20% Small US Stocks and 40% Government Bonds had a SAFEMAX of 4.5%. The media took this and ran with it. It’s known as the “4% rule” today.
These are the different portfolio sizes you need, net of Social Security and other income, given a retirement income need with SAFEMAX:
Liability Matching has the explicit goal of matching cash to each year in retirement. You do this by purchasing a bond to mature for each year in retirement. The investor then receives a cash payment each year to live on. A 30-year retirement means buying 30 individual bonds. This process was posited by William Bernstein in a tiny, but technical book, titled The Ages of the Investor. The bonds recommended are Treasury Inflation-Protected Securities known as TIPS. With TIPS, the core retirement portfolio becomes a bond ladder. Each year, with each bond, you climb a financial rung. Bernstein uses TIPS because the bonds provide inflation protection. Inflation is the slow grinding of higher and higher prices, which swindles the investor overtime (we wrote about it here).
Again, net of Social Security and other income sources, portfolio sizes under Liability Matching:
How much you need for retirement is, therefore, dependent on the process you use.
SAFEMAX comes with stock market volatility and the very real possibility of seeing your nest egg drop in value. With SAFEMAX, you outsource some of your savings to market growth over time. The positive is that you may need a smaller starting account size.
Liability Matching doesn’t come with volatility and can be more emotionally appealing for retirement planners who don’t want to watch their net worth fluctuate in retirement. Yet, it also doesn’t come with much chance to leave any money to heirs. It also requires a higher starting portfolio value. William Bernstein has been known to say that Liability Matching is for those who have won the game and can stop playing.
Really, SAFEMAX or Liability Matching are both good options. Either gives you an idea of how much you need for retirement. With an uncertain future and not knowing how long retirement can last, however, deciding whether SAFEMAX or Liability Matching suits your goals is only the starting point.
Good retirement planning needs to incorporate a wide variety of assumptions that tend to change over time. Your retirement plan should change too. That’s why it’s the process of planning and not the plan itself that may set you up for a successful and secure retirement.
Adam K. Wright, CFA, CFP®
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