It’s time for part 4 of my 4% Rule series. In part 1, I introduced the concept of the 4% Rule. In part 2, I talked about why you need a retirement budget. And in part 3, I explained why you should separate the thought of investment portfolios from retirement portfolio.
Last time, I told you I’d continue that post about retirement portfolios with some examples. I also said I’d talk more about setting up a retirement budget, which can be difficult to do when you are planning for something potentially decades in the future.
Ready? Let’s go.
Retirement Portfolio Example #1: Traditional Retirement, Low Investable Assets
Frank and Lynn are a 66-year old couple who want to retire, but they don’t have much saved up. They’ve owned a small business for many years and always put any excess money back into the business to help it grow. This allowed them to earn a good income during their working years, but now that it is time to shut down the business, they don’t have a large investment portfolio to help fund their retirement.
They know they want about $3500 income per month during retirement. That’s $42,000 per year. However, they only have $100,000 in savings. $100,000 would only give them $4,000 per year ($333 per month) if using the 4% Rule, right? That’s not going to do it.
This situation sounds pretty dire at this point. They are nowhere near where they need to be if you are only looking at investment portfolio.
But Frank and Lynn are also at Full Retirement Age for Social Security. Their combined benefit from that is $3000 per month, or $36,000 per year. Combine that amount with their $4000 per year from their savings ($36,000 + $4000 = $40,000), and now they are very close to their goal of $42,000 per year.
They could work one or two more years to add more to their savings and probably be good to go. Or they could try to reduce their expenses a little. Option #3, they can work just a few hours each month to make up the difference.
In this example, having a fairly small investment portfolio is okay because their retirement portfolio (investable assets + Social Security) is large enough to support the vast majority of their needs. They will have to adjust their plans a little bit, but they’ll be okay.
I know a couple that’s doing something similar. They are working for friends in their old career field two or three weekends per year. That’s only a few dozen hours total each year, but the money is enough to pay for their annual cross country roadtrip!
Retirement Portfolio Example #2: A Military FIREe
Let’s say Sam, a married E-6 with 16 years of service, is looking into the future and trying to figure out how much money is needed for retirement. Sam has a non-working spouse and children and lives off base in Dayton Ohio, so they are making about $67,000 annually (base pay, BAH, BAS only). They currently spend $60,000 including taxes and save/invest the remainder. They have just paid off the last of their non-mortgage debt and have $42,000 in retirement investments.
The couple has determined that they will need about $60,000 in retirement income as well, because they want to move to a lower cost of living area but won’t have tax free BAH and BAS anymore. As we said in part 3 of this series, the investment portfolio for that kind of income at a 4% withdrawal rate is $1,500,000 because $60,000 times 25 is $1,500,000. If that’s how much Sam needs to have in investment accounts before retiring, that’s going to take a long time!
Let’s say Sam gets a promotion and retires from the military at 23 years. Using this calculator, we see that an E-7 retiring at 23 years in 2025 will receive about $36,000 in pension pay in year one. And oh yeah, another 7 years of service usually means at least one more PCS, so let’s say they add a rental property that nets $2000 in profit each year.
Now they have $38,000 in expected retirement income (pension + rental) before touching investments. $60,000 – $38,000 leaves a $22,000 gap. $22,000 times 25 is $550,000 – that’s the goal they are now working towards for their investment portfolio.
Oh but wait…retirement is in the future. $60,000 in 2018 dollars isn’t the same thing as $60,000 in, say, 20 years.
Hmmm….let’s look at that retirement budget again.
Figuring Out A Retirement Budget Years Ahead Of Time
The first thing you need to know how to do is how to account for inflation. This part is easy.
Let’s say you like your current budget and want to continue living on that amount in perpetuity. In that case, figuring out your future retirement budget is easy. You simply multiply the gross (pre-tax) amount you need by the expected inflation rate for however many years out you are projecting. Let’s do the math for Sam.
Sam wants $60,000 in pre-tax retirement income, and wants to retire by age 55. That’s 20 years away, so inflation is going to have a big impact.
It’s impossible to know in advance exactly how much inflation will be. First of all, uh…we can’t tell the future. But also, not everybody experiences inflation the same way, because we don’t all buy the same stuff. Somebody who moves a lot is going to feel inflation in housing costs much more than a person with a 30-year mortgage who has already been living there for 20 years. And a car person will feel transportation cost inflation more than someone who drives a 15-year-old Civic.
To keep it easy, I like to estimate inflation at 3%. That’s about in line with historical inflation, and it’s good enough for my purposes.
How To Account For Inflation In A Retirement Budget
Okay, so we know the desired income in 2018 dollars ($60,000). We know how many years out we are calculating for (20). And we have an estimated average inflation amount (3%). From here, the math is easy.
$60,000 x 1.03^20 = $108,367
If inflation rises at a steady 3% per year (it won’t, but it’s close enough) then Sam will need about $108,000 annually. If you aren’t a math person and that equation doesn’t make sense to you, here it is in longform:
- $60,000 x 1.03 = $61,800 (then keep multiplying the result by 1.03 to find out the next year’s inflated amount)
- $61,800 x 1.03 = $63,654
- $63,654 x 1.03 = $65,564
- $65,564 x 1.03 = $67,531
- $67,531 x 1.03 = $69,556
- $69,556 x 1.03 = $71,643
- $71,643 x 1.03 = $73,792
- $73,792 x 1.03 = $76,006
- $76,006 x 1.03 = $78,286
- $78,286 x 1.03 = $80,635
- $80,635 x 1.03 = $83,054
- $83,054 x 1.03 = $85,546
- $85,546 x 1.03 = $88,112
- $88,112 x 1.03 = $90,755
- $90,755 x 1.03 = $93,478
- $93,478 x 1.03 = $96,282
- $96,282 x 1.03 = $99,171
- $99,171 x 1.03 = $102,146
- $102,146 x 1.03 = $105,210
- $105,210 x 1.03 = $108,367 BOOM!!!
And yes, for all of you who are thinking “but taxes will be different in retirement! Sam won’t really need that much!” That may be true. It will depend on what kind of income and retirement accounts Sam uses. Planning as if all of the money will be taxed as regular income is the safer bet when you are this far out.
Now Let’s Figure Out Sam’s Investment Portfolio Needs
With a required projected income of $108,000 (rounding for ease), Sam has some work to do. That would be an investment portfolio of $2,700,000 if Sam planned to use only investable assets and the 4% Rule!
Ah, but Sam has that pension. And in 20 years, the annual payout is no longer about $36,000. It has also grown with inflation and is now worth over $53,500 per year. That’s nearly half of Sam’s income needs.
And oh, that rental property income has also matched inflation (we’ll assume the house isn’t paid off yet to keep this conservative). $2000 * 1.03^20 = $3612 in rental profit each year. Again, it’s probably actually a lot more by then, but we are planning conservatively.
Let’s call their non-investment income a nice round $57,000, shall we?
That means Sam & Co still need to replace about $51,000 from their investments. So if they are planning to use the 4% Rule, that means…
$51,000 x 25 = $1,275,000
Sam needs an investment portfolio with approximately $1.275 million by 2038 in order to use the 4% Safe Withdrawal Rate.
How does Sam get there? Well if you remember from earlier, Sam currently has $42,000 in a retirement account. And they are saving $7,000 per year. This is an oversimplified chart, but you can see that if Sam commits to a few things, it can happen:
- Make small raises to the contributions ($600/year except more in the promotion year)
- Put 100% of the pension into investments from military retirement in 2025 until total retirement in 2038 (this assumes the post-military career will pay for all living expenses)
In 20 years, Sam’s family goes from having $42,000 in investments to having well over $1 million! And now, at age 55, Sam is ready to retire. And because Sam is retiring after turning age 55, they can take the money out of retirement accounts before age 59.5, penalty free.
(We haven’t talked about that one yet, but it’s another way to access retirement account money early)
Even better, in 20 years they may have paid off the house, so their expenses will go down. Or maybe the kids are out of the house, and their expenses go down from that. As long as Sam & Co can keep their lifestyle inflation in check, they should be good to go!
Not expecting a Pension?
No worries. You should still calculate out your retirement budget in future year dollars. This will help you narrow down your retirement portfolio and investment portfolio needs much more accurately than just multiplying your current expenses by 25.
Why is that important? Well, it’s going to give you a much more accurate goal for your retirement planning.
I was recently in a conversation with someone about this and their preferred method was to only use present day dollars. They are planning to retire 7 years from now, and had set their goal as their current expenses times 25. When I mentioned that inflation would mean they would end up well short of what they needed, they said their plan was to recalculate when they were 1-2 years away from retiring.
IMO, that’s not a good method. It’s really easy, but it’s not very accurate. For instance, if that person’s current expenses were $40,000/year and they were using this method, then they would be looking for an investment portfolio of $1,000,000 ($40k x 25 = $1M). And they would, presumably, set up their finances to make that goal.
But at 3% inflation, in seven years their income needs would be $49,195/year to maintain the same lifestyle. All of a sudden they don’t need $1,000,000…they need $1,230,000! They would be $230,000 short, which means they would have to keep working for several years longer than planned just to maintain the same standard of living.
You can do that if you want, but I’d much rather do a more accurate projection now and then aim for what I’ll really need.
TL;DR: Remember that arcade game where the basketball hoop moves? Aim for where it will be when the ball reaches it, not where it is when you take the shot. You may not score every time, but you’ll be a lot closer to the hoop!
Do you have another method for figuring out how much money you will need in retirement? Share it in the comments!
Gentle Reminder: I am not a financial advisor. I have never been a financial advisor. I will probably never be a financial advisor. I like talking about money. You should probably talk about your money with a financial advisor before taking advice from someone on the internet.
This is such a straightforward way to explain the impacts of inflation. I feel like this is something a lot of people pursuing FIRE kind of ignore unless they’re within striking distance. And why leaving your money in a low interest earning bank account is such a bad proposition.
Yes, exactly, and by then you are thinking you are at the end when really you still have a long way to go. Anybody who has ever hiked the Incline at Pike’s Peak is familiar with the false summit – that’s what not accounting for inflation can do. You get excited because you are “almost done” and end up sprinting to the “finish” only to realize you still have to slog through another section. I’d rather know that my goal will take 20 years than to think it will take 15 and end up devastated when I still have to work another 5!
Should I multiply military pension by 25 and add to assets? Would this be considered a type of bonds in my total portfolio?
You can, but (personally) I don’t understand why you would. As far as I can tell, the only purpose is to make people feel good about their net worth…it’s an ego thing.
Instead, I recommend simply reducing your concept of what your net worth “needs” to be. Have you read part 3 of this series yet?
https://militarydollar.com/2018/01/13/retirement-vs-investment-portfolio/
I was so happy to read this. I belong to several FI groups, but have always been made to feel that we should not even think of retiring.
My husband had a forced retirement in July, he’s 62, I am 55 and disabled. He is planning to find a part time job, but hasn’t yet.
No Debt, house is paid off. (Worth about $350K)
Our monthly expenses are $3000 x 12 = $36,000
His Pension is $1166 x 12 =$13,992
His SS is $1499 x 12 = $17,988
My SSDI is $935 x12 =$11,220
TOTAL IS: $3600 x 12 = $43,200
That’s enough to cover all of our expenses and continue to save a little each month. When he get his part-time job (up to 17K while on SS), we will start adding to our Roth’s again, get him that truck he has always wanted and travel a little.
ALSO, we have a very small retirement portfolio
$143,500 in VTSAX that we don’t need to touch.
Would you consider us FI with so little in investments?
Thank you
Yes, definitely!!
The only thing that worries me here is either your expenses going up significantly, or that pension disappearing. Is there any risk of that happening?
With the $143k in stocks and the $7k extra each year from the “guaranteed” income sources, you are looking at a pretty darn safe income of about $13k more than you need. That means that even if the pension disappeared, you are still pretty okay. The part time job will make your financial position a little safer for sure, but it isn’t necessary so long as your gross expenses stay under your gross income.
Great job!!!
Thank you!
The Pension is pretty secure. It is the local government (City) that we live in. It also has a built in COLA, and it continues at the same amount for me if my husband dies first.
I don’t see expenses going up, and included in the current expense is a second house (vacation) that we could sell or rent. And, we could downsize our current home too.
We also have close to 11K in a MoneyMarket Acct.
Thanks again, this is what I figure over and over too, but continue to hear that we don’t have near enough to retire.
God Bless You.
Keep asking questions until you feel comfortable. You sound like you are doing well to me!
Very informative. This is a good way to consider inflation. Another way is to use a 5% expected return (assumes inflation adjusted) so the estimate is in today’s dollars. I like this approach because we know what kind of money we need now (current expenses).
Your method gives your real retirement number. Maybe use both. One to consider what you need in today’s dollars and one to be honest about how large that number will be in future. Great piece!
Using real (inflation adjusted) returns can help make sense of the numbers since people tend to freak out over how large future day dollar amounts are. Just don’t use it as the dollar goal! It won’t end up being enough.
I love this article!
But I’m a little scared with the numbers I’m seeing. If we want to retire in 20 years and make $100,000/year, that comes to about $181k in 20 years. Using the 4% rule, we would need a $4.5m nest egg.
I’m sure we could reduce our expenses to not “need” to live on $100k/year, but it gets complicated if we end up moving into a higher cost of living area. This helped me iron out the numbers more accurately in a future post I have scheduled. Thanks for sharing!
Thanks Chris!