Saving for Retirement-How Much Will You Really Need?

Saving for Retirement-How Much Will You Really Need?

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