What sort of annual income is needed beyond that which is provided from sources such as Social Security and a pension? Calculating retirement income carries a wide array of variables. To name a few, we need to take into consideration the following: current age, retirement age, current savings, portfolio asset allocation, required income, projected inflation rate, projected portfolio risk, projected market return, taxes, pension income, Social Security income, and annual savings.
At the core of any retirement plan is a savings plan. The Golden Rule of Investing is simply, "Save as much as you can as early as you can." The operative word is early. William J. Bernstein lays it out in stark language in his book "The Investor's Manifesto," where he writes:
Each dollar you do not save at 25 will mean two inflation-adjusted dollars that you will need to save if you start at age 35, four if you begin at 45, and eight if you start at 55. In practice, if you lack substantial savings at 45, you are in serious trouble. Since a 25-year-old should be saving at least 10 percent of his or her salary, this means that a 45-year-old will need to save nearly half of his or her salary. Most 45-year-olds will find this nearly impossible, if for no other reason than the necessity of paying living expenses, payroll taxes, and income taxes.
Using Bernstein's 45-year-old as an example, what are the possible projections and requirements to lower the probability of running out of money in retirement? For this analysis I will be using Geoff Considine's software, Quantext Portfolio Planner (QPP).
Assume the retirement income will come from four possible sources: S, P, W, and I, where S = Social Security, P = Pension, W = Work during retirement, and I = Income from the portfolio. Individuals who do not plan to supplement their retirement income with additional work (W) will need to derive more income from the portfolio in order to meet retirement income needs. The same is true if there is no pension (P) plan. Even Social Security income carries uncertainty for the 45-year-old. We assume inheritance is zero and taxes play no role in the following calculations.
Assume this individual plans on living on $50,000 per year in today's dollars. Annual income from Social Security, pension, and work after retirement are $13,000, $11,000, and $6,000, respectively. This means the portfolio income will need to be $20,000 per year to meet the $50,000 goal. Here is how we will accomplish this. (The dollar values are approximations and need to be adjusted to fit each individual.)
The assumptions for the QPP analysis:
- Age = 45
- Inflation = 3.5%
- Savings of $200,000
- Annual Contribution = $6,000
- Retirement Age = 66
- Projected Annual Return of S&P 500 = 7.0%
- Portfolio Annual Income = $20,000
- The portfolio is a simple five-ETF allocation as shown below.
The following portfolio is made up of Vanguard's Total Market ETF (VTI), Vanguard's International ETF (VEU), Vanguard's Total Bond ETF (BND), and two iShares, Barclays 20+ Year Treasury Bond (TLT) and Barclays TIPS Bond (TIP). The percentage allocated to each is shown in the following screenshot. Note that the portfolio carries a rather low potential risk of 11.7%.
Click to enlarge all images.
With the above portfolio, this investor has a 10% probability of running out of money by age 81 and a 50% chance by age 100. The odds are quite good that pulling $20,000 per year out of this portfolio will not significantly endanger this retiree.
While $200,000 may sound like a large sum to save by age 45, one can see that many of the figures are quite conservative. What if there is no pension and work after retirement is difficult to find? Somehow one needs to make up another $17,000 in income from the portfolio.
The options are limited. Work longer before retiring, save more each year, or plan on living on less. One can set up a riskier portfolio, but that could lead to a bad conclusion.
If two individuals were to combine the above income projections, then the probability of meeting retirement goals ($100,00 in this case) seems quite doable. The way to ease strain on portfolio income is to follow The Golden Rule of Investing.