Saving For Retirement - How Much Will You Need?

Saving For Retirement - How Much Will You Need?
By John Ruppel

How much do you need to save to fund your retirement?

If you've ever looked what kind of nest-egg you are going to
need to retire, you've undoubtedly come across the standard rule
of thumb only allows withdrawing 4% a year if you want to have
your savings last at least 30 years.

So if you wanted to start withdrawing $80k a year, you would
need to have $2 million dollars in savings. Now that is a mighty
sum, and many may consider it out of reach, especially if you
are starting late in the game.

But, why only 4%? If the stock market averages 11% a year, why
shouldn't your nest-egg last forever if you were taking out
anything less than 11%. Let's take a quick look at the original
study that forms the basis of this recommendation to understand
its underlying assumptions. With that information we will see if
we can shape our investment strategies to give us more from our
savings.

The original work that many of these projections are based on
was a paper by Philip L. Cooley, Carl M. Hubbard and Daniel T.
Walz. As you read through this work, you'll find a few basic
assumptions:

1) The goal of the analysis is to maximize the likelihood that
your nest-egg will last for the desired period of time (in the
study it is varied from 15 to 30 years). This is quite different
from maximizing the most likely size of the portfolio.

2) The analysis is done by running a simulation using the
historical data from 1926 to simulate the probable rates of
return on your portfolio.

3) It also assumes the CPI (Consumer Price Index) predicts the
inflation rate that you would need to match in your withdrawals
(e.g. if you took $10k out the first year, and the CPI in the
simulation went up 5%, in the 2nd year you would withdraw
$10.5K)

4) The rate of withdrawal is never modified based on the
portfolio performance. (Basically you would never reduce your
spending as a function of your remaining funds.)

5) No tax or transaction costs were taken into account.

The working assumption was that the portfolio would need to
last 30 years. This matches the most common retirement scenario
(retire at 65, median life expectancy would be around 20 years,
but a 50% chance of greater than 20 years life expectancy).

Finally, the only investment options were those with historical
returns tabulated in the Ibbotson report, basically the S&P 500
as the stock market, and a family of differing maturity bonds
for a bond portfolio.

With those constraints, then it turns out that you would not
pursue a strategy of maximum returns on your portfolio (which is
the case with a portfolio of 100% stocks), but more one that
gives the best risk/ reward performance. The portfolio that gave
the highest probability of lasting 30 years was found to be a
75%/25% mix of stocks and bonds, even though a 100% stock
portfolio yielded about 1% more a year, the risk (as measured by
the standard deviation of the annual returns) was reduced by
about 20% with the

diversified portfolio. For a 4% withdrawal
rate, there was a 98% probability that it would last 30 years.

So, what are the factors that would allow us to increase the
amount we could withdraw each year (or in effect reduce the
amount we need to save)?

1) Reduce the number of years you want to ensure income. The
only practical way to do this is to retire later. Helpful, but
not the solution most of us want to count on. Also, to give some
idea of how effective this is, if the target lifetime of your
nest-egg is reduced from 30 to 25 years, the withdrawal rate
can't even be increased from 4% to 5% and still keep a greater
than 90% probability that it will last the target lifetime. You
have to reduce the target time period to 20 years just to
increase the withdrawal rate from 4% to 5%.

2) Accept a lower inflation rate. If you think your costs will
be fixed, or expect that your rate of spending as you hit the
80's and 90's will go down, it may be appropriate to target a
higher rate of withdrawal. Of course this has it's own set of
risks, but the reality is that most 95 year olds are not
traveling, eating out as much, keeping a vacation home, etc. as
most 65 year olds. The flip side of that is the medical and
extended care costs, which aren't captured by the CPI anyhow.

If you assumed no inflation at all in the analysis above, you
could increase your withdrawal rate to 6% and still have a 98%
chance the portfolio would last 30 years. That may not seem like
much, but it's a 50% increase in income.

3) Increase the returns on your investments. This is the holy
grail that most folks look for when evaluating their investment
performance. While that can be helpful, keep in mind that the
best result above was achieved with a lower yielding, lower risk
portfolio than the 100% stock portfolio.

4) Reduce the risk of your portfolio. This is actually the key
to success, especially when coupled with an increased return. To
give some idea of the leverage of risk, if you can cut the risk
(in this case the standard deviation or the amount of variation
of the annual returns) in half without increasing the yield at
all, you could increase the amount withdrawn each year by more
than 50%.

Few investors understand the impact of improving the risk
reward ratio of their portfolio. Not only will that help stay
the course on following our investment plans, but in the long
run it can actually reduce the target amount needed to sustain
the a retirment income stream.

About the Author: John Ruppel writes for
http://Fundztrader.com. Fundztrader offers model portfolios
featuring Fidelity Mutual Funds, Fidelity Select Funds, and
Exchange Traded Funds Trading Systems. More information and a
free newsletter are available at http://www.fundztrader.com

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