It's always an interesting experiment to ask people how much money (in today's dollars) they think they will need to retire comfortably. I've found that a lot of folks like to throw out the nice, round figure of $1 million. It's a reasonable guess, but usually it's just that: a guess. I wanted to dig deeper and figure out just what it takes to retire comfortably at age 65.
Like any retirement calculations, this one involves many assumptions. But as long as our assumptions are reasonable, say 6% for equity returns rather than the 10% figure that many used to us, we can come up with a very reasonable estimate for how much money one needs to retire comfortably with.
Let's start with the assumptions I used for the couple we will look at:
Inflation (CPI) | 3.00% |
Current Age of Both People | 45 |
Age Of Retirement | 65 |
Age When Both People Have Passed Away | 95 |
Social Security at age 67 (combined) | $30,000 per year |
Average Savings Rate | $10,000 per year |
Total Investment Balance Today | $500,000 |
Recurring Annual Expenses in Retirement | $50,000 |
Investment Mix Before Retirement | 90% U.S. Value Stocks, |
Investment Mix During Retirement | 60% U.S. Value Stocks, |
Investment Location | 50% in taxable accounts, 50% in IRAs |
Return Assumption Value Stocks | 6% per year |
Standard Deviation Value Stocks | 16.20% |
Return Assumption Treasuries | 1.5% per year |
Standard Deviation Treasuries | 7.20% |
There are two ways to think about how much money this couple will need in order to retire at age 65. The first way to analyze the situation is to calculate how much they need at retirement such that they do not run out of money before they both pass away (age 95 using our assumptions). I calculated using our retirement planner that they will need about $800,000 (in today's dollars). This figure, along with the assumptions we used, ensures that they do not run out of money before they hit 96 years old.
The other way to analyze this couple's situation is to calculate the probability that they will not run out of money in retirement given the assumptions we have used. Using Monte Carlo analysis I calculated that the probability they never run out of money is only 40%. Why only 40%? Because stocks can be volatile, and in Monte Carlo simulations this volatility can lead to years with very poor returns. Some of these returns in some of the simulations are poor enough to cause this couple to completely run out of funds in retirement.
I like to see the probability calculation from Monte Carlo at least 75% or higher. So let's ask another question: What can this couple do today in order to boost the probability of never running out of money to 75%?
Part of the issue is that this couple is 40% in treasuries in retirement, which earn them only 1.5% per year. This is below the rate of inflation. Many retirees are desperate for income, but simply cannot find it in bonds these days. But what if we were to move them into high quality dividend paying stocks that generate closer to 4% per year in dividend returns (which includes dividend yield and dividend growth) and 2% in price appreciation? A few of my favorite dividend payers for retirement portfolios that have consistently raised their dividends over the years are Johnson & Johnson (JNJ), Sysco (SYY), AT&T (T), Wal-Mart (WMT), Coca-Cola (KO), and Eli Lilly (LLY).
Company | Div Yield | ||
1 Yr Div Growth Rate | 5 Yr Div Growth Annual Rate | ||
JNJ | 3.60% | 7.00% | 9.40% |
SYY | 3.70% | 3.80% | 8.40% |
T | 5.00% | 2.30% | 4.80% |
WMT | 2.10% | 9.00% | 16.00% |
KO | 2.50% | 8.50% | 10.00% |
LLY | 4.50% | 0% | 3.10% |
Instead of placing 40% of their investments into treasuries at retirement, I put that amount into the above stocks and equally weighted them. I also assumed that these dividend payers are less volatile than an equity index, which has been shown to be true given their relatively steady dividend contributions to total returns. I assumed a standard deviation (volatility) of 12% for the dividend paying stocks.
With all of this extra dividend income helping to cover expenses, the probability of them never running out of money rises to 65% from 40%. This is not quite the 75% figure we were shooting for, but we're certainly much closer. We can tweak the plan further and ask this couple to save a little bit more before retirement. If they save $2,000 more per year, this gets them to the 75% probability figure.
Each person and couple has a different situation and might need to change a variety of things in order to retire earlier. But it is usually impossible to tell whether or not you can retire when you want until you sit down and actually run through the numbers. At that point you can begin running interesting scenarios that will tell you what you need to do to get to your goals.