When can you afford to retire? If you’re still working, that’s an important question with an even more
important answer. Unfortunately, the question can be difficult to answer.
Of course, you’d like to get the most out of your financial resources in retirement. The problem lies in two
areas: all those variables you have to deal with and massive amounts of uncertainty as to what the future
holds. In my experience, there are far too many people out there who think the answer can be derived by
using a simple formula or rule of thumb — probably because there are nearly as many people out there
who’d like to sell you a book or tape or CD or Web site calculator based on this myth.
The truth is that the answer must be carefully calculated and considered in each and every case. There
is, however, a general answer that will help to focus the analysis and guide your thinking: You can
consider retiring when the combination of your guaranteed income and your withdrawals from your
personal resources will cover your expected spending needs.
Practically speaking, a preliminary analysis would start with your expected spending needs, say an
annual allowance, in today’s dollars. Don’t forget that taxes are part of your spending need. Then
compare your spending need with your anticipated sources of guaranteed income in retirement, like a
Civil Service Retirement System or Federal Employees Retirement System annuity and Social Security
If your spending needs, on average, are expected to be lower than your guaranteed income, you’re
probably in good shape for retirement. But, if like most people, you’d like to spend more, the analysis
becomes more difficult. Now, you’ll need to know whether that nest egg you’ve accumulated will support
the difference between what you’d like to spend and what you know you’ll have coming in every year.
The answer depends primarily on how much money you’ll have to start with, how money will be affected
by investment performance and inflation during the years spent in retirement and how long your
retirement lasts. These factors produce the two major sources of uncertainty you must deal with in
retirement planning: longevity and investment returns.
Since you don’t know exactly how long you’ll live or what the investment markets will deliver from one
year to the next, you can’t safely fix a withdrawal rate from your investment portfolio that will exhaust it at
some future date assuming a uniform annual rate of return.
In order to be confident that you won’t unexpectedly run out of money, you’ll need to exercise a strategy
that is conservative enough to eliminate all but the most unlikely coincidences of bad luck — living to age
110 and falling victim to a severe and sustained bear market early in retirement, for example.
But, conservative in this case does not mean investing all of your assets in certificates of deposit,
Treasury bills or the Thrift Savings Plan’s G Fund. It means combining an investment strategy and rate of
withdrawal in a way that produces a sufficiently high expected ending portfolio value over a wide range of
time horizons. In practice, this requires a retirement plan that produces healthy investment growth at the
expected rate of return for the investment strategy you’ve selected.
To illustrate the concept, assume you are considering retiring and you have collected the following
- You’re 62 years old and single with no dependents.
- You’d like $50,000 to spend each year in retirement, after taxes and adjusted for inflation.
- You’ve earned a FERS annuity of $20,000 per year.
- You’ve earned Social Security benefits of $18,000 per year
- You’ve accumulated $250,000 in your TSP account — the total of your retirement savings.
Assuming that you’ll give up about 30 percent, or $11,400, of your income to taxes, on average, each
year, your $38,000 in FERS and Social Security income will cover about $26,600 of your $50,000 annual
spending requirement. I realize the FERS formula for cost-of-living adjustments will deflate the value of
that income over time, but I’ll ignore that here for the sake of simplicity in illustrating a concept. There remains a $23,400 spending need that must be met by withdrawals from the TSP account. But, in order to
produce this amount after taxes, you’ll have to withdraw about $33,400. Initially, the rate of that
withdrawal as a share of the account balance will be a little over 13 percent.
As I’ve mentioned in previous columns, lots of real-world analysis over the years tells me that in a
scenario like this, even with a carefully selected and managed investment strategy, a 13 percent initial
withdrawal rate, particularly if the withdrawals are adjusted for inflation each year, is too high to be relied
on. Something between 4 and 6 percent is more reasonable. The older you are, the higher the
percentage can be.
In this example, you can’t afford to retire. Using a 6 percent withdrawal rate, you’d need to have about
$550,000 in your TSP account to be confident in your decision to retire.
Of course, there are other factors that must be taken into account — things like varying rates of inflation,
uneven or changing spending patterns, dependent needs and many others — but this should help to
illustrate the basic approach to determining whether you can afford to retire. The rest is just algebra and
predicting the future. Simple, right?
Written by Mike Miles
For the Federal Times
Publication February 26, 2007