How much money will you need before retiring? This obviously is very important question, but also a very difficult question to answer. There are many factors and assumptions that go into estimating the income that will be needed in retirement. With so many estimates and assumptions, there is a high probability the estimated number will be incorrect.
A lot of popular “one-size-fits-all” advice can be found on the internet, such as, “People need at least 70% of their pre-retirement income during post-working years.” In calculating what your savings will be at retirement, many use simple assumptions such as a 10% contribution rate, 4% salary growth, a 6% return on investments; and a 25-year retirement period to finance, and so on.
If your investments are growing at 6% every year and you are withdrawing 4% each year, then you will not run out of money, even with 2% inflation. The problem that I have with such estimates is that market does not move in a straight line. What happens when the market tanks for several years?
Sometimes Bad Things Happen
Consider 2008 when the S&P 500 lost a third of its value. A retiree will still have bills and thus need to withdraw a certain amount of dollars. This dollar amount is likely fixed, which means it will be more than the 4% estimated. For example, if your living expenses are $40,000/year, you would need a one million dollar portfolio to support it if you limited your withdrawals to 4%. Assuming your portfolio lost 33% in 2008, that would leave you with $667,000 dollars. Taking a flat $40,000 from it would result in a 6% spend rate, more than the 4% maximum many experts cite. Another alternative would be to limit yourself to 4% which would be only $26,680, well below the $40,000 needed.
Once you get behind it is hard to catch up. Let’s say you spend the full $40,000 needed to meet your expenses, this leaves you with $627,000. To get back to the one million needed to generate the needed income of $40,000 at 6%, your portfolio would have to grow by 59% in 2009.
Dividends Provide A Safety Net
To mitigate the risk associated with relying solely on capital appreciation, consider introducing an income component to the equation. In addition to bonds, some high-quality lower-risk dividend stocks could help provide a steady income allowing you to rely less on selling securities to harvest their capital gains.
Astute entrepreneurs will tell you it is good to diversify your income streams to minimize the risk of one or more of the streams drying up. The same is true in retirement planning. We shouldn’t rely on any single income stream (social security, pension, 401(k), etc.), but instead we should look to diversify our income streams. Quality low-risk dividend stocks make an excellent addition to our retirement portfolio, and the good new is, you don’t have to wait until you retire to figure out what income it will generate.
How Much Money Will You Need To Retire?
