Financial Strategy #3: Setting Your Retirement Number

The book Your Stronger Financial Future: The Eight Essential Strategies for Making Profitable Investments lists eight misconceptions, truths, and strategies to help readers deal with a variety of major financial issues. I'll be highlighting these in several posts and giving you my thoughts on them.

Today we'll look at strategy #3 which deals with planning for inflation's impact on retirement savings. Then, it helps you estimate your retirement number. The book says the following on this subject:

• The misconception: The Fed skims 5 percent from our currency, causing inflation, which ruins our savings.


• The truth: A central bank has positives and negatives.


• The strategy: Identify the inflation-adjusted amount you need at retirement.

These three aren't really the meat of this section. IMO, the interesting stuff is when they help you determine your retirement number as follows:

What specific amount of money do you need to reach in order to retire successfully? How do you determine that number?

Twenty. Your number is 20 times the amount of money you are spending this year. If you are living on $50,000 this year, then your retirement number is $1 million. If you are living on $200,000, your retirement number is $4 million.

They then give three guidelines that add specifics to this formula:

1. Do not multiply 20 by your gross income. For example, if you make $100,000 a year but $40,000 goes to taxes and you save $10,000, then you are spending $50,000. Your number is $1 million ($50,000 after taxes and savings x 20).

2. Your number, the pile of money you need to retire, does not include Social Security and also does not consider the effects of inflation on your non-Social Security assets. When added together, these two at worst will cancel each other out.

3. Your savings should be held in liquid assets -- not in your business, not in the value of your home, not in the peat moss in the backyard.

And finally, these qualifiers:

The formulation of your number assumes you have no other debt and the mortgage on your house is paid in full.

Here's my take on this:

• I'm not sure why they take out taxes. Are they assuming you won't pay taxes in retirement?


• We don't have any debt, so we're ok on that front.


• As most of you know, I updated the estimate of my retirement number earlier this year.


• Using their simple formula above actually nets me a number that's well below what I had estimated in my plan.


• Using their simple formula above, I'm ready to retire now. ;-)


• They suggest a withdrawal rate of 5%. It seems a bit high to me, but they justify it well enough in the book.

What's your take on the formula? And if you used it, how close would you be to hitting your number?

Comments

[tllstaco]

We use the formula that you need 25x your desired income in the year you retire. This rule-of-thumb says you can withdraw 4% of your total portfolio per year and have a 90% probability of having it last 30 years. Since we are not retiring this year, we adjust our desired income in today's dollars with 4% inflation and we assume a 5% growth rate for our current investments. We also do not consider social security or the small pensions we have.

Our plan is to live off the income our portfolio produces but we follow the 25x formula just in case we can't get our portfolio large enough to produce the income we desire.

[Old Limey]

I was also fortunate that my company arranged for a lengthy course on retirement planning for employees contemplating retirement. The course was held on company premises, for both the wife and husband, and was held all day on four consecutive Saturdays. The course was taught by an outside consulting company that had made a speciality of this and I found it very useful indeed. They provided information on every aspect and we received a thick binder with all of the material presented.

Retirement is such a personal decision, there is no one size that fits all. Some of my colleagues moved out of the SF Bay Area into rural parts of the state in order to take advantage of lower home prices but the majority stayed put. We met one couple whose plan was to sell their home, buy a big RV and tour the USA for a year or more before settling down, that however was in the early 90's when gas was cheap.

If you have plans to "see the world" after retiring you need to get all of the most arduous and difficult trips out of the way when you are as young, healthy, and energetic as possible - this is particularly applicable to all of the 3rd. world countries. For us, travel was a very significant factor and it took us from 1993 until 2010 to get it out of our system, taking 2 or 3 overseas trips/year in the beginning before cutting back to just one after my wife had her second hip joint replaced.

My advice is to retire as early as you feel that it is possible. One thing I can tell you emphatically is that "Retirement sure beats Working, and that is especially true when you are in a really happy marriage.

[Apex]

I do not feel this 20 times number is a good number.

Some assumptions I am making.

1. I don't want my standard of living going down in retirement.
2. I don't want to have things going well and then half way through retirement I realize that I am going to run out of money if I live another decade or more.
3. I don't want to work until I am 65-70 to have my retirement last long enough. The goal is to retire early not to be able to be able to meet subsistence once I need a cane.
4. Also assuming no other source of income. Other sources of income that are not passive can be risky because things can happen that make you unable to continue to earn that.

So if you plan to retire when you are 65 and die when you are 80 then this formula sounds about right. If you hope to retire at 50 and live to 90, then you are probably taking too much risk with this formula.

I ran some numbers. I assumed 5% return on investments. This assumes steady 5% with no big draw downs which is a bit of a dangerous assumption unless you are invested in very safe and non-volatile assets and if you are you would be very hard pressed to exceed 5% (you couldn't even come close to getting 5% on new money invested under those terms today, 10 year treasuries don't even pay 2%)

Now if you assume in retirement that you pay an effective tax rate of 15% which includes federal and state taxes and you assume inflation of 4% which given the cost of medical care which will certainly be a big component of retirement costs so I don't think that inflation number is any too high, then here is what you get:

20 times expenses lasts 20 years
30 times expenses lasts 31 years
40 times expenses lasts 44 years
50 times expenses lasts 58 years
60 times expenses lasts 75 years

So a pretty good rule of thumb might be to say how ever many years you want it to last, that's about how many times expenses you need to have saved before you start.

It seems to me that to have one blanket number that is supposed to work regardless of when you retire doesn't make much sense. Obviously the earlier you retire the longer it has to last and it is also the case that you are exposed to more risk from increasing inflation or other unforeseen events.

I know I surely would not feel comfortable retiring at 50 with 20 times expenses.

[Jonathan]

At 27, I'm not contemplating retirement. My wife and I simply focus on saving and investing as much of our income as we can by purchasing income-producing (or equity-building) assets. Eventually, our income from these assets will exceed our salary income, at which time we will be able to contemplate retirement from full-time employment. We would continue to invest in assets, and ideally, our income would continue to grow throughout our life, while our "nest egg" would always be growing as well. Under these circumstances, "x times expenses for x years" becomes irrelevant.

[Apex]

@Jonathan,

We are both taking a similar path with income producing assets. I don't plan to use a formula anything like this either as I expect once I reach the cross over point my income and asset base will be larger each and every year with no draw down. However most people do try to reach a point of living off a nest egg and for those people I think the formula of 20 times expenses could easily leave them a bit short.

[Luis]

It is hard to predict retirement with a formula for those like us who have full time jobs and work as property managers in real estate on the side. For instance, who can answer me how many homes will I be able to purchase in the next 10 years considering the question mark of moving home median values?

I think the 20x rule can work for those who are experts in finance. They can move in and out of different asset classes through their retirement and they can do it without paying exorbitant fees on a CPO. They can be the types who live minimally, enjoy spending much of their time in free to low costing activities, have moderately sized homes, are heirs to well to do parents, etc so forth.

[Apex]

@Luis,

I can answer you. I will give you the number I decided on for myself about a year ago. It's 150%.

Once you have properties that throw off cash flow of 150% of your current expenses you can be done if you like (caveat: this assumes your properties are not in a state of disrepair with large bills coming, and that your mortgages are mostly fixed rates and relatively long term in length).

This gives you plenty large enough buffer to weather any reduction in rents which is likely minimal because rents have never experienced the boom bust cycle of house values. Rents just simply don't fluctuate in value like houses do because wages don't support it. If you had just experienced an unprecedented spike in rental rates then some caution should be used. It also gives you enough extra cash flow to continue to slowly expand the business if you so choose. Inflation increases will slowly continue to grow both your asset base and your rents which will protect you from increasing costs.

You could try to make a leap to full time real estate before 150% but it doesn't leave you much room for error.

[Rich Schmidt]

@Apex, thanks for that. Our retirement plan is multi-faceted, with rental properties, Roth IRAs, 403(b)'s, a pension, and (maybe) Social Security all in the mix.

Are you blogging about this stuff anywhere? Or do you know any good blogs I should be following about renting/property managing?

[John]

While static plans based on averages are fine as a first approximation, I think you really need to use a tool such as Firecalc that simulates a range of possible conditions based on market history. The market is just too volatile to ignore this especially as you get nearer retirement.

[Apex]

@Pastor Rich,

I keep getting people asking me about blogging on Real Estate. I guess maybe I should take the hint. Unfortunately I do not currently do so nor do I find much out there in the way of really good Real Estate blogging to point to.

My Realtor has a blog about real estate investing that he has written for a number of years. It's pretty good and has a good amount of info in it if you go back in the archives. Unfortunately in the last year or so he has not added much good new content. But I do recommend going back into the archives and reading it from the beginning. He owns over 20 units himself so he has some good insights. The blog can be found here:

http://www.minnesotainvestmentrealestate.com/post-archive

There are 36 pages of posts so I would recommend going back to page 36 and working your way forward if you are interested in soaking in some of his wisdom.

http://www.minnesotainvestmentrealestate.com/post-archive/page/36/

Good Luck

[jdgjdg]

The 20X rule seems horribly low. We are still a decade or more away from retirement, but my rules-of-thumb translate to roughly 90X income.

Maybe I'm overly conservative, but I use a 4% withdrawal rate so that the principal doesn't decrease except for market fluctuations, expenses not going down in retirement even when correcting for inflating, ignore Social Security, and allow for a 50% market correction.

[jim]

"The Fed skims 5 percent from our currency"

Huh? What do they mean by that? I am no expert on the Federal Reserve System... but I really don't think it works like that.

[Apex]

@Jim,

There is no shortage of people who find the Fed to be a boogie man and can come up with all measure of nefarious activities that the Fed undertakes. I don't pay much attention to people who complain about the Fed. They rarely understand what they are talking about. Ask them to propose an alternative and they usually run to getting off of FIAT currency and returning to the gold standard. Then I know I am really talking to a loon and can go find something more interesting to discuss such as what characteristics of paint affect the speed at which it will dry.

[Evan H.]

Is it that the Fed, by printing more money, will cause an inflation rate of 5% per year?

[Apex]

@Evan,

They certainly may. We have rarely exceeded 5% inflation in the last 20 years but we may again and if it lasts they will raise interest to kill it.

I don't really understand the big fear of inflation. It's not like we have people sitting on big piles of cash that is getting worth less by the minute. We have people sitting on big piles of debt that are getting less costly by the minute if you have inflation.

If inflation is so bad then deflation must be great right? Then our dollars would buy more. So for all of those people who have a mortgage, a car loan, credit card debt, furniture loan, etc, etc, etc, deflation makes them cost more and inflation makes them cost less. And by the way it makes the federal government debt cost less to pay off too.

If instead of debts you have assets like houses, land, stocks, factories, etc, inflation makes them worth more, deflation makes them worth less.

If instead of debt or assets you hold a big cream can full of money, then yes, inflation is eating away at your purchasing power.

So by show of hands, how many cream can holders of cash do we have here? Come on, don't be shy. Cream cans? Anyone? Beuller?

[Rich Schmidt]

@Apex,

Thanks for the links! You're right, there's some good stuff there. I've been having trouble finding good blogs to follow re: real estate investing that aren't focused on flipping. I just have no interest in that.

Right now we're landlords for 4 tenants: 2 in single-family homes and 2 in apartments in the house we live in. I'd like to invest in a couple more homes/duplexes in the next year or two while mortgage rates and home prices are so low. That should get us to the place where all our properties (including our home) are totally paid for by rental income, including maintenance & potential vacancies. We're close now... but we want to cover those maintenance costs!

Anyway... thanks!