Managing Income in Retirement: How Much is Enough to Retire?

Written by Lisa Brown, CFP®, CIMA® on January 1, 2016

How much is enough? For many investors, determining the answer to this question is often a top priority in their financial planning process. Another way to ask it: How much do I need in my investment portfolio to retire and maintain a certain lifestyle for the rest of my life, with little chance of running out of money? Not only is this a question that pre-retirees must plan for, but those who are currently retired must continually review whether they continue to “have enough.”

A sophisticated and preferred approach to determining “how much is enough” is using portfolio simulation. This method simulates the future based on historical returns and correlations of the various major investment classes. The results are based on thousands of trials and project the value of an investment portfolio over many years taking into account distributions, taxes, inflation, and a historical range of random investment returns using a mathematical process. Investment results do not come in a straight line, meaning you may average 7% per year, but rarely will actually earn exactly 7% in any given year. Therefore, it is best to see how an investor’s results could be impacted based on variable and random investment returns over time. This method of projecting the future better communicates the potential best and worst case scenarios in order for the investor to understand the impact of planning decisions and to be more confident in turn.

This Chart illustrates a hypothetical age 60 retiree who desires to spend $100,000 per year adjusted for inflation, and wants to assume they incur an extra $30,000 of annual long-term care expenses, in today’s dollars, from age 85-90. They begin retirement with $2.5 million of investment assets. In Portfolio #1 they invest 60% in stocks and 40% in bonds. Portfolio #2 invests 30% in stocks and 70% in bonds. As is evident from the illustration, maintaining a higher allocation to stocks increases the chances they won’t spend down their principle while maintaining the ability to buy the same amount of goods and services (including healthcare costs) in their latter years of retirement. As inflation is one of the greatest risks a retiree will face, protecting one’s purchasing power should be a key factor in portfolio design.

Portfolio simulation can be applied to an investor’s annual planning using the 4% Withdrawal Principle. Portfolio simulation supports the conclusion that you have a low probability of depleting your principle over time if you withdraw no more than 4% of your beginning portfolio balance. For example, if you have $1 million in your portfolio on January 1st, studies indicate you can safely plan to withdraw $40,000 per year, adjusted for inflation each year. The higher the annual withdrawal rate, the greater the probability of running out of money. In fact, based on portfolio simulation, we estimate that increasing your withdrawal percentage from 4% to just 6% increases your likelihood of running out of money dramatically (from 6% to 48%).

The time period in which you retire will have an impact on your portfolio, and could steer you off course from staying within a safe withdrawal rate. Looking at historical market returns for a 60% stock/40% bond portfolio, if an investor retired in 1973 their average portfolio return the first five years of retirement was 2.40%. If another investor retired in 1993, their five year average return was 15.45%. The 1973 investor would have been spending down principle during those first five years if they budgeted to retire and withdraw 4% per year.

Retirement planning should never be “checked off the list” the day you decide to retire. Personal income and lifestyle decisions change, family goals are adjusted, health issues may arise, and economic conditions vary. Making periodic changes to your portfolio and spending habits in retirement is necessary to ensure long-term financial success, a low probability of running out of money, and increased peace of mind that you’re still on track.