So this question presents the ultimate dilemma: will you have enough to retire and live the type of lifestyle that you want? A lot of us will answer “no” to this question. With defined contribution plans calling on employees to take on the burden of funding their retirement, most have answered with a resounding “I’ll do it later.” According to the Employee Benefit Research Institute, half of workers are not confident they will be able to meet their needs in retirement. And I’m sure that some of the other half live in denial.
How much will I need?
As you might already assume, capturing the number that you will need to save to live comfortably in retirement proves pretty difficult. You have to deal with many variables: your investment returns, inflation, the sustainability of social security, etc. Online calculators don’t help much either. I can get vastly different results using the same assumptions.
Most advisors use one of two starting points for calculating how much you will need in retirement: 1) dying with zero and 2) living forever.
The first method involves a precise analysis using a Time Value of Money formula to predict how much money you can take from your portfolio over a certain time frame. Over this period of time (e.g., 30 years), you take an amount from the portfolio that uses all of the funds available to you. To me, the lack of margin of error in this method produces too much risk. If you live beyond that zero-money point, you will end up needing money at one of the most vulnerable times in your life.
A second approach involves estimating your anticipated living expenses (based on your current expenses) and then divide that number by your real (inflation adjusted) rate of return. William Bernstein, in The Four Pillars of Investing, calls this the “back of the envelope” method. He thinks a reasonable rate would be 4%. So if you predict that you need $40,000 per year to live on, you have to amass $1,000,000 by the beginning of your retirement. ($40,000/.04).
This method still has its risks. Assuming too high a rate of real return will cause you to deplete your portfolio. To hedge against this risk, Bernstein recommends withdrawing a consistent percentage of your portfolio, rather than a consistent dollar value. For example, assume you have a $1 million dollar portfolio and you can safely withdraw 4% of it a year. Instead of taking $40,000 every year, you determine 4% of the portfolio’s value every year. So while you may take $40,000 the first year, you may only take $36,000 the next, if your portfolio dropped by 10% (and was thus only worth $900,000). By taking the specific percentage and averaging the real inflation return, you don’t have to touch the principle investment. Therefore, your money will let you live forever.
The Monte Carlo Analysis
A Monte Carlo Analysis provides an alternative to the methods above. The analysis is a computer simulation that runs millions of “what if” scenarios and computes the percentage of times whatever strategy you propose will succeed. It uses your initial nest egg amount, expected real rate of return, length of your retirement and the portfolio’s risk (standard deviation). This simulation allows you to assume many different scenarios and try to determine which plan has the most chance of success.
As you can see, none of this analysis is an exact science. However, assuming that you will live forever and using the back of the envelope method and/or the Monte Carlo Analysis for calculating how much you need in retirement can reduce some of the inherent risk. In addition, starting as early as possible can help increase your odds of success.