A seesaw has a lot to teach us about retirement planning. Think of the length of your career – the time you have, or will, spend earning money – as being proportional to the length of one side of a seesaw. The length of the other side is proportional to the length of time you will spend in retirement – the time you’ll spend spending.
If the career side of the seesaw is long, and the retirement side short, a relatively small rate of savings can support a relatively large amount of retirement spending. On the other hand, shift the location of the seesaw’s supporting fulcrum – the retirement point – toward the career side, and the amount of savings required to support a given rate of retirement spending increases.
In fact, as you shorten your career and lengthen your retirement, the resources required to support your retirement dreams balloon rapidly. Past a certain point, you’ll have to increase your savings faster than you’ll have to decrease your retirement spending to keep things in balance. Rather than using leverage to your advantage, leverage has the advantage over you.
Hopefully, this image helps to illustrate the need for care when considering when to retire, particularly if retiring might mean that you’ll wind up on the short end of the seesaw. To responsibly answer the question “Can I afford to retire?” you’ll need to analyze the relationships between the various components of the retirement equation, including existing resources, future income, future needs and the time horizon. Your existing resources should be pretty easy to quantify in most cases and include assets than can be used to support your future spending needs. If you have assets that will later be converted to produce spendable income – a vacation home that you plan to sell later, for example – it’s easiest to consider the spendable proceeds as future income, rather than an existing resource.
Estimating your future income can be a little tricky, but is usually just a matter of requesting an estimate or finding the right formula. For most feds, this means estimating your annuity, and maybe your Social Security income. The third basic component, time horizon, is a tricky one since most of us are not sure how long we will live. You can be very conservative, as some do, and figure that you’ll live long enough to be interviewed by a local journalist just for living so long. The benefit from this approach is that it’s likely to be safe. The penalty is that it’s likely to unnecessarily restrict your spending while you’re alive and induce you to leave a lot of life “on the table” in the end.
Make the mistake of assuming that you’ll die young, and you could wind up running out of money while you’ve still got plenty of living to do. Either mistake is a sad one to make, and in order to minimize the risk, you’ll need to consider the outcomes for a range of possible scenarios while taking their probabilities into account. This is what Monte Carlo simulation analysis is designed to do, but it should be used only by someone who knows what he is doing and who has your best interests in mind. Also, keep in mind that your analysis must also include investment returns and the possible effects of inflation and taxes.
While I don’t recommend using financial rules of thumb to live by, I can give you some information that might make your retirement planning job a little easier and your decisions a lot more reliable. If the duration of your retirement is expected to be 20 years, figure you’ll need about $20 in savings, initially, to support each $1, after-taxes, in annual withdrawals, adjusted for inflation. For a 30-year retirement, you’ll need $26; for a 40-year retirement, you’ll need $31; and for a 50-year retirement, you’ll need $35 for each after-tax dollar of annual income from savings.
For example, if you’re retiring at 50 and expect to live another 30 years, you’ll need to have saved about $260,000 to safely support $10,000 of annual, after-tax income, adjusted for inflation, that is not provided by your pension or other outside source of retirement income.
From another perspective, if you give up $10,000 per year in retirement income by retiring early, you’ll need to have saved another $260,000 to compensate. The preceding estimates assume that you’ll invest and maintain the savings in a diversified portfolio equivalent to 40 percent C Fund, 15 percent S Fund, 5 percent I Fund, 3 percent G Fund and 37 percent F Fund throughout the retirement period.
This rule of thumb is not a substitute for proper planning and analysis, but it may help you to determine whether that early retirement is a possibility worth pursuing.
Written by Mike Miles
For the Federal Times
Publication September 28, 2009