Estimate the savings you need to retire
FIRE stands for financial independence, retire early. I was critical of certain elements of the movement while supporting the overall goal. Offering a criticism without an alternative doesn’t help anyone.
Our brains are hard wired to prefer easy answers over nuance. We want to simplify things. That is why we gravitate to basic rules that can be easily understood so we can avoid thinking.
A simple rule can’t account for our differences. To figure out how to achieve a goal like retiring early should involve more than a rule of thumb. It requires thinking.
Before thinking about anything we need to understand the problem we are trying to solve. We all want to know our FIRE number. That is the amount of money we need to retire. The first step is estimating how much we will spend in retirement.
The second step is figuring out your withdrawal rate or how much you can take out of your portfolio the first year. To help figure that out I’ve created a model that accounts for personal differences. In the first article I used the 4% rule as a withdrawal rate. This model provides you to adjust the 4% rule based on your own circumstances.
The challenge with the withdrawal rate is that it needs to be high enough to enable a great retirement but also low enough so you don’t run out of money.
The challenge is the same if you retire a day before you die or if you retire 50 years before you die. Unsurprisingly retiring early makes the problem more challenging to solve.
This model is not simple. But I hope it makes you think about your personal circumstances so you can come up with a retirement plan customised for your own situaton.
A model to figure out when you can retire
Our financial outcomes are driven by more than hard work. And they are driven by more than intelligence. Luck plays a role.
The rule of thumb that dictates how much can you safely withdrawal from a portfolio is known as the 4% rule. If you understand the rule you know it is designed to account for bad luck.
It may seem counterintuitive to create a retirement plan that is designed to account for bad luck. And I understand that. As investors we are supposed to embrace risk to earn our just rewards. But while I understand that point of view, I also disagree with it.
A long-term plan that only works if everything goes perfectly is not a plan. It is a fantasy. When was the last time everything went perfectly over decades? A plan should account for bad luck.
Here is a model for you to come up with a plan to retire, early or otherwise.
Problem 1: Inflation
Inflation is the cost of goods and services rising over time. High inflation over the course of retirement is bad luck and we need to account for it.
Inflation can make or break retirement outcomes. Whether articulated or not the goal of all retirees is to maintain at least the same lifestyle in retirement. That means increasing the amount of spending each year by how much the costs of what you consume increases.
The more inflation over the course of your retirement the quicker you will run out of money. That means less can be safely withdrawn.
The first step to figuring out a plan for retirement is to consider how much of a risk inflation is to your retirement. That is the first tab of the model I’ve put together.
The first step is to consider wants and needs in the context of inflation. Housing is a need. Feeding yourself is a need. Medical care is a need. Most other categories of spending are technically wants. But think carefully about the quality of life you want in retirement.
Going to Europe every August is not a need. In theory that is something that can be cut out of your budget if inflation is higher than expected.
The question is if you want to risk having to cut that out of your budget. Personally, I would rather work a couple more years to enable travel in retirement. That is just me. You need to make your own decision.
I’m attempting to account for both wants and needs in your retirement plan. But what is a want and what is a need is up to each person. If you need to go to Europe every year than add it into your needs.
It is harder to substitute your needs. You always have the option of substituting a more expensive place to live for a cheaper one. You could eat tins of beans every night instead of your preferred dinner. But for many people these are unpalatable scenarios.
Wants are easier to substitute. If you can’t afford to go on holiday to Europe you could go to a cheaper location. If you want to go out to dinner twice a month you could always go out once a month.
Spending on wants also tends to diminish as people age. They just don’t have the interest or physical ability to keep up the pace of activities. Needs tend to stay the same or even increase if you require more medical care.
In the model I’ve applied different withdrawal rates to wants and needs. I’ve done that for all the reasons previously outlined. Most people want more certainty that needs will be meet. Wants can be substituted more easily. But ultimately it is up to you to categorise your spending.
I’ve used the classic 4% safe withdrawal rate for needs. I used a 5% withdrawal rate for wants. That is a Morningstar calculated safe withdrawal rate based on the historical propensity to reduce spending as retirees age. This isn’t perfect but I think it is a good substitute for the potential variability of spending for wants.
Reflecting the same thinking I also applied any non-portfolio income for retirement to needs. That includes the age pension, annuities, and a reverse mortgage. The age pension and some annuities are indexed for inflation which provides additional protection. We offset spending with the other income as the purpose of this exercise is to figure out your retirement goal or how large your portfolio needs to be to support retirement.
Problem 2: The length of retirement
One of my criticisms of the FIRE movement is the use of an investing rule of thumb that isn’t designed for longer retirements. The 4% rule was created to achieve a 90% success rate over 30 years.
How long you need your portfolio to last has a direct input in the likelihood of running out of money. This should be obvious. More years of inflation have a more profound impact on your retirement outcomes. The impact of market drops just as you retire have a greater impact. Low returns over a longer time-period matter more.
The second step of the retirement tool I put together involves adjusting the withdrawal rate for the length of your expected retirement.
One of the biggest challenges of retirement planning is that none of us know how long it is going to last. The question you should consider is what life expectancy underpins your retirement plan.
It is easy to figure out when the average person dies. That fact is irrelevant if you are an outlier. If you outlive the assumptions in your plan you are at a greater risk of running out of money. If you die early you could be forgoing spending and leave a large legacy. Complicating matters is the unknown impact on lifespans of advances in medicine.
I’ve used the baseline of a 30-year retirement embedded within the 4% plan. Based on Morningstar modelling I have reduced the withdrawal rate for retirements longer than 30 years and added to the withdrawal rate for retirements less than 30 years.
Problem 3: Certainty of retirement outcomes
Throughout this article I’ve alluded to the 4 factors that influence how long a portfolio will last when you start taking money out of it. They are:
the sequence of returns
the level of returns
inflation levels (which is a substitute for how much withdrawals will rise)
the percentage withdrawal rate in the first year of retirement
The goal is to solve for one of the four factors. Three of them are unknown. All that can be controlled is the percentage withdrawal rate in the first year of retirement. And since it is within your control that is the factor that must be solved.
A safe withdrawal rate needs to account for all manner of variations in the unknown factors. To test the possible variations and create the 4% rule the variations were tested using something called a Monte Carlo simulation.
The Monte Carlo simulation will run every combination of the historical occurrences of the factors to determine in how many scenarios a portfolio will run out of money before the end of the retirement period.
This is when luck comes into play. Some scenarios have all the good combinations. Returns are strong and inflation is low. Some have all the bad combinations. The market drops significantly early in retirement, returns are low, and inflation is high.
I’ve used the assumptions that go into the 4% rule as a baseline. The rule uses a 90% success rate - in 90% of the scenarios the retiree will not run out of money over 30 years.
Adjusting the success rate will change the withdrawal rate. If a retiree wants more certainty the withdrawal rate is reduced. If a retiree is comfortable with a lower success level the withdrawal rate will increase.
A retiree can use the model to show the impact of increasing and decreasing the success rate.
Problem 4: Taxes
This is only applicable if you retire prior to your preservation age. The preservation age is when you can access super. For anyone born after 1 July 1964 the preservation age is 60.
Upon reaching the preservation age a retiree can set up a pension super account and withdraw money tax free. Taxes on capital gains and dividends will also not apply.
The 4% rule is meant for pre-tax withdrawals. If some of that withdrawal gets eaten up by taxes it lowers what is left over to spend.
For a retiree that has reached preservation age and can withdrawal funds tax free this section is irrelevant. However, it is relevant if funds are going to be spent from non-super accounts that are subject to taxes.
Using a single withdrawal rate for an early retiree with super and non-super accounts doesn’t work. But it is almost impossible to create a model given the dependences on personal circumstances.
First you need to account for capital gains taxes based on the tax bracket that you will fall into. Then you need to incorporate the cost basis of each asset that will sold to fund your life and the length of time you’ve held the asset.
If more than $18,200 of capital gains are generated in any year (including any other income earned) taxes will be owed. This will reduce the amount left over to spend. Each early retiree will have to consider what impact taxes will have on their non-super accounts.
I would suggest creating two different models - one for non-super assets to support you prior to preservation age and one for super assets to support you after preservation age. The withdrawal rates should be different and that is ok. You will have two goals to work towards. For the non-super assets include a buffer for capital gains taxes when you sell assets to support your spending needs. You can add in an additional spending need to pay those taxes.
Final thoughts
No model is perfect. But I do think this is a better approach than simply relying on a rule of thumb. At the very least this should provide some food for thought for anyone considering retirement outcomes.
Play around with the different inputs to see the impact of various decisions. I hope this helps whether retirement is just around the corner or decades away.
Humble Goode is here to help. For any further information regarding estimating the savings you need to retire comfortably, please contact our team of experts. Our advisors are ready to assist you in creating a tailored retirement plan based on your unique financial situation and goals.
Original Source: https://www.morningstar.com.au/insights/retirement/250046/estimate-the-savings-you-need-to-retire
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