Q: When I look at the approximate amount of money I think I need to retire, I calculate that I’ll need to save half my take home income for 60 years so that I can plan for 30 years with the same spending after I stop working. How does anyone manage to save enough to retire?
A: There are some misconceptions here common to newer investors. If you’ve been through a few cycles of our Observatory session you likely understand these principles well, but a refresher might still be useful. This information could also be useful for family or friends who are only just now beginning to think about a financial plan in retirement, so please don’t hesitate to share if you know someone just getting started.
The most obvious good news here is that you don’t have to replace your income. In this highly simplified case, if you are working for a lifetime with a 50% savings rate, you only have to replace half your income because you were living on half your salary the whole time! This example is extreme, but even when a typical worker considers things like their 401k contributions, taxes paid, and money spent on commuting and business attire, they realize there’s no need to replace 100% of nominal salary in retirement to have the exact same lifestyle as today.
It’s true that if you had to save every dollar you need for retirement before you retire, you would need work for a very long time. We are very fortunate that today we enjoy the power of capital markets which allow us to buy stocks and bonds to earn meaningful real returns after inflation. For the last 50 years, US large cap stocks have returned about 10% per year, which was a tremendous tailwind to the balance of investment accounts. By staying invested during your working years, your portfolio can grow much more quickly than money in a savings account. In fact, by mid-to late career, it’s common to see market gains in a typical year far exceed the impact of contributions in retirement accounts.
Note that we didn’t say stocks have yielded 10% a year. There’s a strong instinct among investors and particularly retirees to “live on the interest” by spending bond interest and dividend income but never touching the principal in their investments. That probably comes from a time when retirees could buy intermediate term bonds and enjoy 5%+ yields, which is not the case today. Today’s lower yields, rise of stock buybacks, and relatively low capital gains tax rate mean that dividends might actually not be the most desirable way to enjoy retirement returns. Retirees should definitely not be concerned about selling a small portion of the investment portfolio to fund annual expenses.
But how much money do you actually need? Every situation is different, but a general rule of thumb is that you only need to save about 25x your annual spending in order to retire. A famous paper known as the Trinity Study suggests that in the first year of retirement a retiree can spend 4% of the value of their investment portfolio, then continue spending that same amount indefinitely, adjusted each year for inflation. Markets will go up and down, and spending in retirement will likely rise and fall at different times, but the paper suggests (and our Observatory process confirms) that using this approach means a retiree would have been very unlikely to run out of money during most historical periods with good available data we can test.
To directly answer the question, people retire by living below their means, investing the extra money in diversified portfolios, and staying invested in a prudent diversified allocation throughout retirement. Rules of thumb are useful but don’t tell the whole story, so at Telarray, we are always excited to use our proprietary Observatory process to help show you what that process might look like for you.
As always, we look forward to any questions you might have at your next scheduled meeting and are always happy to schedule to meet with family or friends that could benefit from our process as well. Retirement can be an overwhelming subject, so the peace of mind from a well-tested financial plan can be just as important as the details of the plan itself.