“This magic moment. So different and so new.” – The Drifters
How do you know when you have enough money to retire? You might have heard of the 4% rule–Take out 4% of your portfolio in the first year for expenses and then adjust for inflation after that. But this was designed for 65 year-olds, not early retirees.
I’ve never seen an article that takes into account both the longer retirement time-frame AND the fact that annual withdrawals can be bigger in early retirement before Social Security and Medicare kick in. If you retire between the ages of 50 and 60, you can withdraw somewhere between 3%-4% as I describe below.
So what’s your magic number? There are 4 important factors that you need to look at: Your annual expenses, your assets, your age, and your risk level.
Early Retirement Expenses
What will your annual expenses be in retirement? Your current expenses are a good baseline. Then you can add and subtract in different categories. Potential subtractions include: commuting expenses, restaurants (if you have been too busy to cook), a house cleaner and yard service (if you had them and are willing to go back to cleaning toilets), accountant (if you paid one and want to do your own taxes), and clothing expenses for work. I have to admit that I have continued to outsource some of the items that I thought I might start doing after retirement. Finally, if you have kids at home and soon to leave the nest, you can estimate how that will change your expenses.
How about increased expenses? The biggest for me has been health insurance, which had been mostly paid for by my employer; you can go online and price that out. The next biggest was travel. Do you have a bucket list of places that you’ve always wanted to visit? If so, your travel expenses will probably go up during retirement. Don’t forget to budget for cars with whatever frequency you buy them as well as home repairs, because those might not be in last year’s expenses
Age 65 and Beyond
Now for some good news. When Medicare and Social Security kick in (at age 65 for the former and sometime between age 66 1/2 and 67 for the latter), the amount of money you need to withdraw from your portfolio will significantly shrink. While medicare does have premiums, I estimate that mine will be 1/3 of what I am paying for my medical plan today. You can look online to see the estimate of what your social security will be. The estimate is based on your highest 35 years of pay and assumes you will keep making what you are now. So if you didn’t get in 35 years because you retired early you need to zero out the remaining years and lower the estimate. If you have a spouse who didn’t earn a lot and won’t collect much social security, he/she can get 1/2 of your payout instead.
When you put Social Security and Medicare together, they will lower the amount you need to withdraw by at least 20%/year for most of your retirement years. This means looking at a retirement model for early retirees will underestimate what you can spend unless you correct for this, as I will below.
There are a few subtractions and one big addition that you can make when calculating the assets that you will make withdrawals from each year.
The first is future expenses that you can anticipate and will have for a limited number of years. It will be simpler to subtract these from your assets. What are they? Let’s start with expenses associated with your children. If tuition expenses are in your future, hopefully you have a 529 or UTMA account, but if you don’t, put that expense in a separate mental account and subtract it from your assets. Do you plan to help out your kids in the future with things like wedding expenses, grad school, house down-payment, college savings for grand-kids? Those are all things to take into account as well and subtract from your assets before determining your withdrawal rate.
The next is your mortgage if you haven’t paid it off. Like college, that’s an expense that shouldn’t last throughout your retirement so you need to look at if differently than other expenses. The easiest is to subtract the mortgage from your assets and consider the interest a wash with the return you’re making by not paying it off. If your interest rate is high you really should pay it off (I still have a small mortgage that I haven’t paid off because I’m only paying 2.75% interest).
Have you planned for long-term care expenses for your final years? My kids will take care of me isn’t a good planning strategy. Your options are either to buy a generous long-term care insurance policy (topic of a future blog) or to set aside money that you don’t include in your assets calculation when figuring your regular retirement expenses.
Now the big potential addition. Do you plan to downsize? For those of us who live in an expensive housing market, moving to a low-cost area could allow you to cash out half or more of your house. Remember though you will have realtors’ fees and other closing costs and capital gains if your house has appreciated by $500,000 (for married couples) or $250,000 (for singles). If you’ve had a lot of appreciation and you don’t plan to move to a lower cost market it may not yield you as much as you think to downsize in your same town.
What if you don’t plan to move? Should you include your house as an asset you can withdraw? I personally would not because you need to live somewhere, you might need to buy into a retirement home in the future, and it’s a buffer for emergencies you didn’t anticipate. However, you could consider your home equity as your source for long-term care if you are willing to sell it and move into a retirement home or take out a reverse mortgage.
Your retirement savings need to last you for the rest of your life and the younger you retire, the more years they need to last. You can calculate the number of years by looking at your probability to reach different ages.
While the average new life expectancy in the US is 79, the life expectancy for people who have already reached adulthood is higher. There is a 50% probability that a 55 year-old will reach 82 if he is a man and 85 if she is a woman. If they are a male/female couple there is a 50% probability that one of them will live to at least 89.
But planning for the 50% probability means that you have a 1 in 2 chance or running out of money! Most retirement models I’ve looked at suggest planning to age 95, but if you have good reason to think you won’t live that long then you can be more aggressive with your spending (see risk level section below). The table below shows the probabilities for a 55-year old to live to different ages, based on data from the Society of Actuaries. The odds don’t change much if you’re several years younger or older than 55.
Once you know the number of years you need to plan for, you can estimate what’s known as your safe withdrawal rate. As an example using the table below, if you have a $2 million nest egg and you’re 55, you can spend $70,000/year (3.5% of $2 million) with adjustments for inflation throughout retirement. Go to the bottom of the blog to see the assumptions and math behind my table (geek out section).
What if you decide you want to plan for the 75% probability to live to 95 instead of 95%? You can add 1% to the table above–using the $2 million nest egg example, you could spend an extra $20,000/year. That’s a lot of wine and chocolate (or insert your favorite vice)! When we plan for the bad case of 95%, we are being conservative and most likely things will not be that bad. Michael Kitces has found that with the conservative withdrawal rate, there’s a 60% chance that we will end up with more than our initial principal (after adjusting for inflation) at age 95 and a 25% chance that we will end up with twice our initial principal! A good market makes a huge difference over the decades of your retirement and you can adjust your spending upwards if things turn out better. I’d prefer to find out I can spend more than that I have to cut back, but you might feel differently!
Maybe you don’t have $2 million but still want to retire and live on $90,000. Could you take more risk and go with the 75% case? Here are some considerations that might make you decide to go for it:
- You plan to work part-time in retirement
- You’re willing to downsize your house and haven’t included your home equity as an asset
- You’re willing to cut back if the market returns turn out to be bad
- You expect a significant inheritance (I wouldn’t consider inheritance in your assets for the safe withdrawal calculation though, because you never know what your parents’ end of life expenses might be).
Do you need to plan for your assets to last until age 95? If your grandparents or parents have lived into their 90’s you have good genes and need to plan for a longer life expectancy. That’s the case for me and I’m even planning for the 11 percent probability that either my wife or I live to 97.
So was your magic number higher or lower than expected? Good luck reaching your number!
Table Details if you want to geek out
There are a lot of calculators online but you need to really look at the fine print to see if for example, they are looking at pre-tax or after-tax withdrawals and what probability they are assuming (e.g. 95%, 90%, 75%) for not running out of money. Fortunately, I’ve looked through the details of several of these (Fidelity, Bernstein, Capital Group, and researchers such as Wade Pfau and Michael Kitces) so you don’t have to. The methodologies either look at historical 30-year rolling period actual returns (which I don’t like because the sample size is only about 100 of them) or a statistical technique called a Monte Carlo analysis that typically looks at 10,000 scenarios.
For your purposes, the most important thing to understand is the probability of success. Remember that the odds that one of the spouses lives to age 95 is 17% (or if you want to plan to age 97 only 11%). Since investment returns over that period are an independent event, if you take the odds of living to age 95 and then layer on a 90% probability of your assets lasting that long then you only have a 1.7% risk of running out of money. Using a 95% probability your risk is less than 1 percent.
The first column in the withdrawal rate table is from the Capital Group. I’ve used their 95% probability in order to account for the fact that returns in the future might be less than average as stocks and bonds are both near historic highs (they suggest layering on even more conservatism but I think this is a good number).
For the second column, I did a calculation of what percent of retirement you will need to fund before social security and medicare kick in. For example, if you’re 55, then you need to fund about 10 years and then you will have 30 years of social security and medicare (which I assumed will cover 20 percent of your current expenses, but in your case it could be even more). This means you can spend $100,000 in early retirement while using the retirement formula for spending $85,000. Here is how the math works:
(10 years * $100,000 + 30 years* $80,000)/40 years = $85,000/year average
Using similar math, I made adjustments and populated the second column.
The third column is an after-tax estimate and I assume taxes will total 25% of withdrawals. Your own tax rate will vary depending not only on your tax bracket, but how much of your savings are in an IRA/401K/403B (taxed as ordinary income), taxable accounts (capital gains tax rate) and how much of your taxable account is gains; if you don’t want to make that complex calculation you can use my 25% estimate.
I suggest you play around with online calculators yourself or go to a financial advisor (who likely will use a similar calculator) before you make the decision to retire. Fidelity has one that allows you to vary your expenses over time so you can be more precise.