I spend a lot of time helping people understand how much money they will need to meet their retirement goals. I have found that many people thinking about retirement are making simple calculations that can lead to disastrous decisions. For example, I have come across countless people who simply add up their social security and pension payments, assume a high rate of return on their investments, and apply a best-guess tax rate to all of that income. They then compare that to their expected expenses in retirement.
There are so many problems with this approach that I cannot list them all here. But for starters, social security has its own set of complex tax rules, different account types such as IRAs and 401(k)s are taxed differently than other accounts, and using the correct tax code to calculate changing tax rates every year in retirement is extremely important for accuracy.
Today I am going to look at this question in a rigorous manner using our publicly available financial planning software: What will $2 million actually get you in retirement? This is an interesting question because a) Many people believe that $2 million is a comfortable amount to meet their retirement goals and b) We can look at the different ways in which a couple can use this $2 million without running out of money.
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 people used to use, we can come up with a very reasonable estimate for how much money one needs to retire comfortably.
Let’s start with the assumptions I used for the couple we will look at:
Inflation (CPI) | 3.00% |
Current Age of Both People | 65 |
Age Of Retirement | 65 |
Age When Both People Have Passed Away | 90 |
Social Security at age 67 (combined) | $35,000 per year |
Average Savings Rate | None (Already Retired) |
Total Investment Balance Today | $2,000,000 (50% in Taxable, 50% in IRAs) |
Recurring Annual Expenses in Retirement | $70,000 |
Investment Mix Before Retirement | 70% U.S. Value Stocks,
30% Medium Term Treasuries |
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% |
Before generating a retirement plan for this couple the first thing we need to clear up is, what constitutes success? We live in a dynamic world, especially when it comes to investing. So I like to look at the probability of never running out of money in retirement using Monte Carlo analysis, where thousands of scenarios are run, shocking investment returns in every scenario in every year. In this example I will define success as having a probability of at least 85% that funds never run out in retirement.
Using Monte Carlo analysis in our planning software, I calculated that the probability they never run out of money is 97%. This easily meets our definition of success. In fact, this couple can spend more than $70,000 and still succeed, given that our definition of success is that the probability that funds are never depleted is 85% or more.
So how much can this couple spend per year and still have an 85% chance of achieving all of their retirement goals? I ran some scenarios and found the answer to be $81,000. This is the amount they can spend each year and still have an 85% chance of never running out of money.
Yet another question we can ask is, how can they spend $81,000 in retirement and raise the probability of never running out of money? There are really only two ways to do this since this couple is already retired (assuming they don’t want to go back to work): They can find higher returning investments with the same level of volatility they currently have or they can find investments that have the same returns, but less volatility.
My favorite way to reduce volatility while maintaining reasonable levels of return is to buy high quality dividend paying stocks that have a history of rising dividends over time. 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), Altria (MO), and Coca-Cola (KO)
Company | Div Yield | | |
5 Yr Div Growth Rate | 10 Yr Div Growth Annual Rate |
JNJ | 2.9% | 7.4% | 9.7% |
SYY | 3.0% | 3.7% | 7.5% |
T | 5.6% | 2.2% | 3.9% |
MO | 3.9% | 8.7% | N.A. |
KO | 3.0% | 8.3% | 9.3% |
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I replaced their Equity Value fund with the stocks listed above, equally weighted. I kept the same total return assumption, but lowered the level of volatility to the historical levels of these stocks. That is, I reduced the volatility level from about 16% to 13% per year.
The probability that this couple never runs out of money now jumps from 85% to 93%. This is a large jump, solely due to the fact that they are now invested in more stable, solid dividend paying stocks instead of an equity index fund.
Each person and couple has a different situation and might need to change a variety of things in order to meet their retirement goals. 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 using a rigorous calculator that takes into account proper tax rates and various account types. At that point you can begin running interesting scenarios that will tell you what you need to do to get to your goals.