Projecting Retirement Needs

Projecting Retirement Needs

Projecting Retirement Needs

I vividly remember my professor describing a simple formula for how much money I’d need to retire: just multiply your annual expenses by 25

I vividly remember my professor describing a simple formula for how much money I’d need to retire: just multiply your annual expenses by 25

I vividly remember my professor describing a simple formula for how much money I’d need to retire: just multiply your annual expenses by 25

I thought I had this whole retirement planning thing figured out. How tough could it be? Retirement bliss, here they come!

The guideline described was the ‘4% rule’. You would multiply the annual cash required by 25, which would allow you to ‘safely’ withdraw 4 per cent every year and have it last approximately 30 years before running out of money.  So if you calculated you’d spend $8,000 a month, you would need $2.4 million in retirement savings.

It didn't take long for the harsh reality to set in that accurately projecting an investor’s retirement funding needs is an exercise in educated guesswork and fortune-telling.  Will you end up living until 102 like your great aunt, or shuffle off this mortal coil at 75 due to a health issue? Will your investment returns over 30 years of retirement resemble a terrifying roller coaster or relatively smooth sailing? What about healthcare costs projections in the latter decades of life?

There are just too many moving parts to be able to accurately calculate a minimum retirement sum with any degree of certainty.

More importantly, there are a number of critical flaws in this simplistic calculation. It assumes achieving an inflation-adjusted investment return of 6 per cent every year. And that retirement expenses remain stable over time. And that the lifespan does not go beyond 30 years.

Discovering that this calculation method wasn’t accurate, I set out twenty years ago to create a calculation that was more accurate and would provide better results for calculating a retirement sum: We need a better model, that can be tailored to an individual’s specific situation.  After applying it to many individual cases, we also developed a use for investors who have more than enough money for their own life, and wanted to leave a comfortable nest egg for their children and future generations.

The retirement sum calculations are shown in the table.

First we tackled the assumption of an inflation-adjusted 6 per cent annual return. Such a portfolio would need too high an allocation to equities to achieve its target, leading to significant volatility in the yearly returns. Taking out 4 per cent of a portfolio value for living expenses during a bear market would significantly shorten the time until the value of the portfolio was used up.

We broadly defined three types of investment portfolios, a conservative one that returns 3 per cent over inflation, a balanced one at 5 per cent over inflation, and an equity one at 7 per cent over inflation.

At the top is the number of years until the retirement capital is fully used up. This is the investor’s life expectancy, with enough additional margin. The last thing anyone would want is to live an additional few years after the retirement nest egg was used up.

Crossing the life expectancy column with the level of risk in the portfolio gives a number that is the multiplier of one’s annual expenditure needs, inflation adjusted.

An investor who expected to live for an additional 20 years, using a conservative (3 per cent return above inflation) who needed $8,000 a month for all living expenses ($96,000 per year), would need 15 times this amount, or $1.44 million. They would withdraw $96,000 the first year, and continue to do so every year while adjusting the withdrawal up by the annual inflation.

Choosing a less conservative portfolio strategy means that you need less money to meet your retirement needs. However it also comes with a higher risk of not meeting your retirement goals.

This is why the recommendation is always to choose the most conservative investment strategy. This will ensure that the probability of meeting your retirement requirements is as high as possible.  A diversified equity portfolio (the last row) that targets to last 40 years has a 20% chance of running out of money by year 16, and a 50% chance of running out of money by year 36. Would you take those odds of running out of money in retirement? I wouldn’t, and you shouldn’t.

The last piece of this puzzle is that the targeted investment returns must be achieved with the highest level of confidence possible. In other words, you cannot afford to make mistakes in how this retirement portfolio is managed. A return of 3 per cent above inflation (diversified conservative) is far easier to achieve than a 7 per cent return above inflation.

For investors who have more than enough assets to last their lifetime, we encourage them to set up a ‘family multi-generation nest-egg’, using the ‘infinite’ column and the most conservative strategy, which requires 34 times the annual family expenditure. Because this column does not have an end-life where the capital gets used up (i.e. it is structured to last forever), when managed in a judicious and conservative manner, it can be used to provide for future generations of the family indefinitely.

This is the portfolio to rely on as a safety net, which would enable an investor to risk-budget all the other assets appropriately, without endangering the family’s lifestyle.

 

Inflation-adjusted performance

Time until capital is eaten up

20 years  

40 years  

60 years  

Infinite  

3% (diversified conservative portfolio)         

15

24

28

34x

5% (balanced mixed portfolio)

13

18

19

20

7% (diversified equity portfolio)

11

14

14

14

By LEONARDO DRAGO

The writer is head of investments for Singapore at AlTi Tiedemann Global. The views and opinions expressed in this article are solely the author’s and do not reflect the views or positions of AlTi Tiedemann Global or its subsidiaries. This content is intended for informational purposes only and should not be considered as financial advice.