People often ask me if they can afford to retire. The question seems simple, but it can be tricky.
One simple answer is: It depends on how much you need from your investments every year and how much your portfolio is worth.
An even better answer is this: The best time to start retirement is when you have saved more money than you think you’ll ever need. I once described that state of affairs as “the ultimate retirement luxury.”
This is Part 6 in a series of articles I think of as Boot Camp for Investors 2023.
· The first installment was The best way to invest for retirement.
· The second was Seven simple portfolios that have beaten the S&P 500 for more than 50 years.
· The third was How to control your investing losses
· The fourth was How to turn small amounts of money into huge sums later—and why you should invest beyond the S&P 500.
· The fifth was How to retire well, even if you’re not rich.
A few years ago, in this article, I argued that many people could effectively double their retirement income by postponing that first year of retirement by five years.
Assume that in addition to Social Security and other sources of income, you need $40,000 a year from your portfolio, and that anything less than that will likely leave you feeling pinched.
If you have $1 million, that calls for a 4% annual withdrawal rate. As we saw last time in “How to retire even without being rich,” history suggests that, with that set of facts, your chances of success are favorable.
But if you had saved more than $1 million, you would have more money to spend, more money to leave to your heirs, and more peace of mind.
With more savings than you absolutely need, you can take flexible distributions, a fixed percentage of each year’s portfolio value. When your investments have done well, you take out a bit more. And when the market has been unkind, you can tighten your belt a bit—without feeling like you’re giving up essentials.
Depending on how much “extra” savings you have, you might be able to safely take out 5% each year—or even more.
If you follow this link to my foundation’s website, you’ll find a series of tables, each one of which tracks the hypothetical results of a given investment portfolio year by year, from 1970 through 2022, based on a particular rate of withdrawal.
Let’s walk through a couple of scenarios to see how a few portfolios would have held up.
Start by scrolling down to Table E1.4, where you’ll find three columns under the heading “60% S&P 500 Fund / 40% US Bonds.”
These columns assume you had 60% of your portfolio in the S&P 500
and the other 40% in bond funds, and that you began retirement with $1 million and took out $40,000 for your first year. After that, each year you withdrew 4% of your portfolio’s ending balance from the prior year.
The key: As your investments grow, your annual “salary” grows too.
In this scenario, you had less than $40,000 to spend in 1975, after a particularly unproductive year in the stock market. But every year after that, you took out more than $40,000.
If you had started retirement with $1.5 million instead of $1 million, you could multiply every one of those withdrawal numbers by 1.5. Thus, in 1975, you would have withdrawn $54,414.
That’s an example of why it makes so much difference to start retirement with more money.
These numbers assume you had all your equities in the S&P 500.
One relatively painless way to accumulate “more” is to diversify beyond the popular S&P 500. Let me show you a few examples.
One excellent alternative is a four-fund combination composed of equal parts of the S&P 500, large-cap value stocks, small-cap blend stocks, and small-cap value stocks.
You can see how that combination would have fared starting in 1970 if you follow the link above and scroll to Table E9.4, which gives the same information as the table we looked at earlier.
If you follow the same columns, you’ll see that a 60/40 portfolio supplied substantially more than the $40,000 you needed.
Table E9.5 shows distributions starting at $50,000. In this scenario, after 1975, you were always well above the $40,000 that you needed.
For one more example of choosing your equity investments, turn to Table E14.5. That shows the results of withdrawing 5% if your equities were divided equally between the S&P 500 and a U.S. small-cap value fund.
This equity mix carries more risk. But you could offset that by dialing down the overall risk and holding your investments in bonds. This would give you a 50/50 mix of equities and bonds, a ratio that is considered only moderately risky.
Scroll down to 1989 in that table, and you’ll see that you would have had 36% more to spend in your 20th year of retirement: $178,238 vs. $128,570 without the small-cap value (Table E1.5).
Like almost everything else about investing, planning your distributions involves important trade-offs:
· Are you willing and/or able to delay retirement a few years to build up your nest egg?
· Do you care more about spending power in your early retirement years, or more about how much you’ll leave to your heirs?
· How long do you expect your retirement to last?
· Are you comfortable “cutting it close,” or would you rather have a wide margin for error?
· Do you want to stick with the S&P 500, or are you willing to diversify into other asset classes in order to have potentially more to spend in retirement?
There’s no single “right answer” for every situation.
But I’m sure of this: You won’t go wrong by retiring with the comfort and security of having abundant savings.
For more, watch my video or listen to my podcast on this topic.
Coming up next in this series: How to use only two funds over your whole lifetime to accumulate money and later retire on it.
Richard Buck contributed to this article.
Paul Merriman and Richard Buck are the authors of ”We’re Talking Millions! 12 Simple Ways to Supercharge Your Retirement. ” Get your free copy.