Is $1,000,000 Enough

The answer is…it depends.

We all want to believe that retirement planning is a clean analysis that can be run to peg the exact amount of money we need to eventually stop working.

Maybe we need:

75% of income (adjusted for inflation)

10X final year salary

20X final year salary

But what if we want to leave money to our kids?

What if the stock market goes up or down?

Should I put all my money in cash the day I quit working?

There are many variables and it is constantly evolving. Retirement planning is not simple. It is something that is an on-going process that has no beginning or end and adjustments will be need to be made along the way!

I look at retirement planning differently, however.

Expenses Matter More

To me the biggest driver is not income but EXPENSES–Which are also the hardest to forecast. You might be dreaming of playing golf or traveling, but who really knows if that’s what you want to do..

To do the initial planning, clients need a target, so yes we use traditional numbers that focuses on income. But as clients get closer to their 2nd Act, our focus shifts to expenses. That tells us all our true need in retirement.

Some people earn $300,000 and spend $150,000

Some people earn $100,000 and spend $125,000

Both scenarios will create a very different retirement picture.

So back to the original question is $1,000,000 enough? Well, that all depends on withdrawal rates….

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What is a sustainable withdrawal rate?

A withdrawal rate is the percentage that is withdrawn each year from an investment portfolio. If you take $20,000 from a $1 million portfolio, your withdrawal rate that year is two percent ($20,000 divided by $1 million).

However, in retirement planning, what’s important is not just your withdrawal rate, but your sustainable withdrawal rate. A sustainable withdrawal rate represents the maximum percentage that can be withdrawn from an investment portfolio each year to provide income with reasonable certainty that the income provided can be sustained as long as it’s needed (for example, throughout your lifetime).

Why is having a sustainable withdrawal rate important?

Your retirement lifestyle will depend not only on your assets and investment choices, but also on how quickly you draw down your retirement portfolio. (TO PAY EXPENSES)

Figuring out an appropriate withdrawal rate is a key factor in retirement planning. However, this presents many challenges and requires multifaceted analysis of many aspects of your retirement income plan. After all, it’s getting more and more common for retirement to last 30 years or more, and a lot can happen during that time.

Drawing too heavily on your investment portfolio, especially in the early years, could mean running out of money too soon. Take too little, and you might needlessly deny yourself the ability to enjoy your money. You want to find a rate of withdrawal that gives you the best chance to maximize income over your entire retirement period.

How does a sustainable withdrawal rate work?

Perhaps the most well-known approach is to withdraw a specific percentage of your portfolio each year. In order to be sustainable, the percentage must be based on assumptions about the future, such as how long you’ll need your portfolio to last, your rate of return, and other factors. It also must take into account the effect of inflation.

Example(s): John has a $2 million portfolio when he retires. He estimates that withdrawing $80,000 a year (adjusted for inflation) will be adequate to meet his expenses. John’s sustainable withdrawal rate is 4%, and he must make sure that his portfolio is designed so that he can continue to take out 4% (adjusted for inflation) each year.

Other approaches to withdrawal rates

A performance-based withdrawal rate

With this approach, an initial withdrawal rate is established. However, if you prefer flexibility to a fixed rate, you might vary that percentage from year to year, depending on your portfolio’s performance. Each year, you would set a withdrawal percentage, based on the previous year’s performance, that would determine the upcoming year’s withdrawal. In years of poor performance, a portfolio’s return might be lower than your target withdrawal rate. In that case, you would reduce the amount you take out of the portfolio the following year. Conversely, in a year when the portfolio exceeds your expectations and performance is above average, you can withdraw a larger amount.

Example(s):

Fred has a $2 million portfolio, and withdraws $80,000 (four percent) at the beginning of his first year of retirement to help pay living expenses. By the end of that year, the remaining portfolio balance has returned six percent, or $115,200–more than the $80,000 he spent on living expenses.

For the upcoming year, Fred decides to withdraw five percent of his portfolio, which is now worth $2,035,200 ($2 million — $80,000 + $115,200 = $2,035,200). That will give him $101,760 in income for the year, and leave his portfolio with $1,933,440. However, during December of that second year of retirement, his portfolio experiences a seven percent loss; by the end of the year, the portfolio has been reduced by the $101,7600 Fred withdrew at the beginning of the year, plus the seven percent investment loss. Fred’s portfolio is now worth $1,798,099. Fred reduces his withdrawals next year–the third year of his retirement–to ensure that he doesn’t run out of money too soon.

(For simplicity’s sake, this hypothetical illustration does not take taxes in account, and assumes all withdrawals are made at the beginning of the year.)

A withdrawal rate that decreases or increases with age

Some strategies assume that expenses in the later years of retirement will be lower as a retiree becomes less active. They are designed to provide a higher income while a retiree is healthy and able to do more.

Example(s): Bill sets a six percent initial withdrawal rate for his portfolio. However, he anticipates reducing that percentage gradually over time, so that in 20 years, he’ll take only about three percent each year from his portfolio.

Other strategies take the opposite approach, and assumes that costs such as health care will be higher in the later retirement years. These set an initial withdrawal rate that is deliberately low to give the portfolio more flexibility later. The risk, of course, is that a retiree who dies early will leave a larger portion of his or her retirement savings unused.

What determines whether a withdrawal rate is sustainable?

  • Your time horizon: The longer you will need your portfolio to last, the lower the initial withdrawal rate should be. The converse is also true (e.g., you may have health problems that suggest you will not need to plan for a lengthy retirement, allowing you to manage a higher withdrawal rate).
  • Anticipated and historical returns from the various asset classes in your retirement portfolio, as well as its anticipated average annual return: Though past performance is no guarantee of future results, the way in which you invest your retirement nest egg will play a large role in determining your portfolio’s performance, both in terms of its volatility and its overall return. That, in turn, will affect how much you can take out of the portfolio each year without jeopardizing its longevity.
  • Assumptions about market volatility: A financial downturn that reduces a portfolio’s value, especially during the early years of withdrawal, could increase the need to use part of the principal for income. It could also require the sale of some assets, draining the portfolio of any future income those assets might have provided. Either of those factors could ultimately affect the sustainability of a portfolio’s withdrawal rate.
  • Anticipated inflation rates: Determining a sustainable withdrawal rate means making an assumption about changes in the cost of living, which will likely increase the amount you’ll need the portfolio to provide each year to meet your expenses.
  • The amounts you withdraw each year: When planning your retirement income, your anticipated expenses will obviously affect what you need to withdraw from your retirement portfolio, and therefore affect its sustainability. However, because this is one aspect over which you have at least some control, you may find that you must adjust your anticipated retirement spending in order to make your withdrawal rate sustainable over time.
  • Any sources of relatively predictable income, such as Social Security, pension payments, or some types of annuity benefits: Having some stability from other resources may allow greater flexibility in planning withdrawals from your portfolio.
  • Your individual comfort level with your plan’s probability of success.

As with most components of retirement income planning, each of these factors affects the others. For example, projecting a longer lifespan will increase your need to reduce your withdrawals, boost your returns, or both, in order to make your withdrawal rate sustainable. And of course, if you set too high a withdrawal rate during the early retirement years, you may face greater uncertainty about whether you will outlive your savings.

Putting it all Together.

There are a lot of variables that go into retirement planning. Many people think “income” is the most important. I disagree. The top 2 factors in proper retirement planning are 1) annual expenses 2) withdrawal rates. Expenses tell you how much money you need, while withdrawal rates tells you how much you need to take out of your portfolio every year. Knowing and tracking both of these will lead to a higher success rate of living a comfortable retirement!

So the bottom line, is $1,000,000 enough — It depends..

As always, you can consult with me to discuss your retirement income planning.

Look for future posts on the best ways to maximize your investment portfolio and check out my recent post on simple investment advice

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Thanks for stopping by and I hope you achieve financial success!

Previously posted on The Art of Financial Planning.

— Jared Friedman Independent Certified Financial Planner in NJ