I frequently run across “advice” from financial planners, and salesmen who focus on mutual funds, annuities and similar items that suggest that retirees need 80-85% of their pre-retirement income to live off of in retirement. These same voices also emphasize that workers should move to lower risk investments as they approach retirement. By this they mean something like a target date fund that shifts assets from equities to bonds based on some simple formula such as setting the equity share of the portfolio as 100 minus the investor’s age. This is typically combined with a focus on the 4% rule, as though it is some sort of gospel. This often creates a never ending cycle of disappointment that results in the indefinite deferral of retirement. Since your bond-heavy portfolio never gets big enough to generate 85% of your highest income level, you can never retire, and you should pay me 1% of your money each year until you can.
A 50 year old investor with a $100,000 per year income will be told that he needs $100,000 * 85% / 4% = $2,125,000 in retirement savings before he can retire. The expected return on a 50/50 stock/bond portfolio is lucky to be 7%. In addition, if inflation is close to its long term average of about 3%, this high hurdle keeps moving outward and is unlikely to ever be reached. This is simply unrealistic for most people.
Fortunately, this self-serving prognosis from the investment advisor is biased in a couple of fundamental ways. Whenever, I hear someone tell me that I need 85% of my pre-retirement income to live off of in retirement, I have to ask, “Why would I need that, if I only live off of 50% of my income before retirement?” My income just before retirement is not the relevant benchmark. In fact, this figure is likely to be my highest income level over my lifespan. But more importantly, my income and my spending are not the same thing.
Consider a proto-typical 50 year old head of household making $100K per year. Of this amount roughly 10K goes to taxes, 10K goes toward retirement, 10K goes to expenses related to working itself such as gas, lunch, etc. In addition, the next 25K is likely to be dedicated to a mortgage payment. Once we account for these items, this leaves $45 to actually live off of. If this is a married couple at full retirement age, we are likely to be looking at a total of 40K in SSI benefits. A 40 thousand dollar income for a couple who actually lives off of 45 thousand does not need 2 million in a retirement account to supplement this.
Of course, the large assumption I am making here is that the mortgage can be paid down prior to retirement. However, if this is doable, then my test subject actually maintains their standard of living if they can replace the 5K gap between SSI and what they actually spend. Let’s add another 10K for health care, travel etc. We are now looking at a needed nest egg of $15000 / 0.04 = $375,000. This is imminently doable with a bit of diligence and planning.
However, there are two additional huge issues left out here. One suggests that much more is needed, while the other suggests that a good bit less will do. First, it is always wise to make an arrangement for long-term care. Fortunately, it has become commonplace for professionals with 6 figure incomes to purchase long-term care insurance prior to retirement. On the other hand, we have worked under the assumption that the retiree will stay in the home that made the most sense when working.
Currently, millions of Americans are retiring in homes designed to accommodate a family even after the children have long since moved on. If a retiree is seeking to downsize to a lower cost area the impact can be dramatic.
For example, if this family is fairly typical, they purchased a home for $100K 20 years ago that is worth over $300K today. That asset can easily be used to purchase a smaller home for $200K in an area where other expenses such as food can be 10-20% below the rates involved while working. Accounting for these issues, this family can downsize, pocket the extra 100K and hold that as a buffer to deal with settings in which markets temporarily go down. If they need to pull out 15K per year adjusted for inflation, this 100K will easily finance the next 5 years of retirement even after including a 4% inflation rate over that period, and no gains on the 100K at all.
Let’s be clear. If your plan is to retire and travel the world in 5 star hotels, this is not going to work. But if the plan is to live roughly as you have for the past decade minus work related expenses, saving more for retirement, and moving to a house in an area that provides a better fit for a retired couple, I can almost guarantee that you are a lot closer to being able to afford that than you have been told.
