The most important retirement planning task for your last working year is calculating where your income comes from when you retire. This probably seems completely obvious, but it usually isn’t. Your portfolio needs to yield more every year to keep up with inflation.
Inflation is the silent retirement killer. Your income needs to increase every year just to keep up with the rising cost of living. For example, look at how much medical care services costs increase, last year rising 3.7%, according to theBureau of Labor Statistics.
So it is not enough to look at your portfolio and see if it produces enough income this year alone. It needs to continue to grow and produce more income for each subsequent year. If it doesn’t, your buying power and lifestyle evaporate.
Create a cash flow analysis beginning with your income gap (total expenses minus pension and Social Security) in the first year and then project the income gap into the future based on a reasonable rate of inflation. In the last 30 years, factoring in a 3.5% average inflation increase seemed to be enough. But we like to use 4% as a plug number just to be a little more conservative. An abbreviated retirement income analysis might look like this:
Here are the numbers for a hypothetical retiree in 1983. You can see years one, five, 10, 20 and 30 with each year’s inflation increase, a pension with a fixed 2% cost of living adjustment, Social Security income, and the gap that savings needs to fill for each year.
On the far right, we have the average annualized income increase (from the first year of retirement) required to fill the gap. Now compare the cost of living in year one to year 30. You need $184,000 to buy what $80,000 bought in that very first year.
Your portfolio must produce more income every single year in retirement just to keep up. This means its average growth rate must at least equal your withdrawals plus the inflation factor (the last column in this chart).
Let’s say you designate your first 3% to 4% of returns to continuous portfolio renewal so that your future self has the same buying power as your current self and that you withdraw 4% to 5% of your portfolio to meet current needs. Then you need 7% to 9% in average annual returns to just maintain your buying power – to buy THE VERY SAME STUFF!
Obviously, the more you withdraw, the faster you deplete your portfolio. Here is a quick look at how your withdrawal rate might effect how long your portfolio lasts, both typically and in poor markets.
Years of sustainable withdrawals for a 60% equity / 40% bond portfolio:
|Projected Outcomes for typical markets (50% confidence level)||Projected Outcomes for extended poor markets (75% confidence level)|
These charts are created by J.P. Morgan for illustrative purposes only and must not be used or relied upon to make investment decisions. Hypothetical portfolios are composed of Large Cap Growth for equity and US Aggregate for fixed income with projected compound returns projected to be 8% and 3%, respectively. The resulting projections include only the benchmark return associated with the portfolio and does not include alpha from the underlying product strategies within each asset class. The yearly withdrawal amount is set as a fixed percentage of the initial amount of $500,000 and is then inflation adjusted over the period. Allocations, assumptions, and expected returns are not meant to represent any individual’s specific performance. Given the complex risk-reward trade-offs involved, we advise clients to rely on judgment as well as quantitative optimization approaches in setting strategic allocations. References to future returns for either asset allocation strategies or asset classes are not promises or even estimates of actual returns a client portfolio may achieve.
Before you permanently leave your job, ask yourself if you have enough assets that you can live on a small amount (4% to 5%) and leave the rest of your returns in the portfolio to grow and compound. If you are confident that this is so, you are ready to retire. If not, be patient and keep saving and investing as much as you can.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations to any individual. For your individual investing needs, please see your investment professional regarding retirement planning.