Lots of people wonder whether or not they can afford to retire, and the answer must depend on many things.
But if you ask me what’s the best time to retire, the answer is pretty easy: It’s when you have saved more money than you think you will ever need.
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That might seem obvious. But I’ll do my best to show you why it’s so important.
This is part seven in a series of articles I think of as boot camp for investors 2024.
This is a continuation of the previous discussion.
Let’s assume you’re about to retire. In addition to Social Security and any other sources of income, you need $40,000 a year from your portfolio; anything less will likely leave you feeling pinched.
If you retire with $1 million, that calls for a 4% annual withdrawal rate, adjusted every year for actual inflation.
While history suggests you are unlikely to run out of money with that plan, it’s not a good recipe for peace of mind and protection from inflation.
In recent decades, inflation has been relatively tame. But in the 1970s and 1980s, it was a beast. Investors who were unlucky enough to retire in 1970 saw the value of their investments decline significantly for five years at the same time inflation was pushing prices past anything they might have expected.
And even after the market recovered significantly, starting in 1976, the country saw dangerous inflation in 1978 through 1981. In just those four years, the purchasing power of $1 million dropped to $628,560.
This might seem like ancient history, but inflation hasn’t been eradicated. Something like this could happen again.
Back to our original scenario: You retire with $1 million in the S&P 500 SPX, and you need $40,000 that first year, adjusted for inflation after that. Had you done that in 1970, you would have experienced financial trauma through at least the first dozen years of your retirement.
By year 13, in 1982, inflation required you to withdraw not a comfortable 4%, but more than 9% of your portfolio’s value at the end of 1981. Yikes.
Ultimately if you stuck with the plan through the scary 1970s, your portfolio would have held up just fine, leaving you with nearly $6.4 million at the end of 1999, after 30 years of retirement.
But you could not have known any of this in advance, and I think those first dozen years would have been too unsettling for most investors.
You can see how this would have played out year-by-year in a table on my foundation’s website with a catchy title: Table D1.4.
I’ll tell you about two terrific ways to address this problem:
Starting with more money
By far the most reliable way to assure a comfortable retirement is to start with lots more money.
For the sake of discussion — and I know this may sound unrealistic — let’s imagine you retired with $2 million (instead of “only” $1 million) with that same $40,000 need.
In the table, that would double every year-end portfolio value. At the end of 1978, your portfolio would be worth $1.8 million instead of $910,222.
Your inflation-adjusted need in 1979 would remain at $71,830 — but you could thumb your nose at inflation and take out twice that much.
Two giant steps
That’s just the start. With $2 million, you could have taken two more steps that, together, would have nearly tripled (yes tripled) the money you could safely take out in the first 13 years of your retirement.
The first step is to take flexible distributions, each year taking a fixed percentage of your portfolio value at the end of the prior year. That means when your investments do better, you take out more; when your portfolio struggles, you take out a bit less.
The second step is to boost your withdrawal percentage from 4% to 5%, meaning you start with $50,000 in 1970 instead of $40,000.
You can see how this would have worked in Table F1.5.
The three columns labeled “100% Equity” show what would have happened to an all-equity portfolio starting with $1 million and 5% of the year-end value withdrawn each year.
If you started with $2 million, you could have comfortably doubled each year’s distribution, giving yourself much more than you needed. And thanks to the variability of your distributions, your portfolio would never been in any danger of running out of money. (You’ll see that in Table F1.5 if you scroll down the columns.)
As a bonus, by starting with twice as much money, you could have done fine while investing much more conservatively, with only 40% or 50% of your portfolio in equities.
I know what you’re probably thinking: $2 million is more than you’ll be able to save. And if you take this next step, you don’t have to go that far beyond $1 million.
Beyond the S&P 500
History is very clear on the merits of diversifying your equities beyond the S&P 500.
One simple method is to adopt a four-fund strategy, dividing your equities equally among four U.S. asset classes: large-cap blend stocks (the S&P 500 in other words), large-cap value stocks, small-cap blend stocks, and small-cap value stocks.
Over the long haul, each of these other three asset classes has outperformed the S&P 500.
To see how that would have played out, look at Table F4.4.
You’ll see that a 50% equity portfolio had little trouble (except for 1975), providing more than $40,000 every year.
And by the end of 1984, the 15 th year of your retirement, this four-fund mix of assets and flexible withdrawals had grown to $2.95 million, 40% more than the $2.11 million in the portfolio with all equities in the S&P 500. (You’ll find the $2.11 million figure in the corresponding spot in Table F1.4.)
That not only produced substantially higher distributions, but also the enhanced peace of mind that comes from having more assets to draw on if you need to.
Finding the right combination
There’s no single “right answer” for every situation, and the best solution for most people will be some combination of saving more money before retiring and diversifying equities beyond the S&P 500.
In my next boot camp article, I’ll tell you how to find a combination of asset classes and distributions that will apply to whatever amount of money you have at retirement.
If you remember only one thing from this article, I hope it’s this: When you start retirement with more money, you have lots more options from which to choose. For example, taking out 5% every year instead of 4%.
That’s an excellent recipe for peace of mind.
. Richard Buck contributed to this article.
Paul Merriman and Richard Buck are the authors of “
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