Friday, October 28, 2011

How Much Should You Save Now?

You Need More Than You Think
You probably need more savings that you think, especially when using the stock market as part of your overall retirement saving plan. Investing in risky assets like stocks, bonds, and commodities exposes you to uncertainty, while planning a successful retirement strategy involves reducing uncertainty to the point where you can sleep at night and still meet your retirement goals.

Let’s start with a common rule of thumb (ROT) that says that an investor should save 20 times her annual living expenses at the point of retirement. In other words, if you have $100,000 per year in living expenses, then you need a nest egg of $2,000,000 in investable capital. Like most ROTs there is considerable variation with single-number projection given the unknowns, such as how your savings are invested, what inflation adjustments are used, market valuation at point of retirement, and other guaranteed income sources. In addition, it is difficult to manage a 5% withdrawal rate ($100,000 / $2,000,000) for 30 years plus cost-of-living adjustments to achieve a low probability of running out money. Moreover, the possibility of living beyond the typical 30-year retirement planning window is no longer a hypothetical.

The Consumption Ratio
Another technique to calculate a first approximation of a sustainable retirement nest egg size is the Consumption Ratio, provided by the good folks at the Retirement Income Industry Association (RIIA). The Consumption Ratio is your annual Consumption (i.e. living expenses) divided by your Financial Capital (which is more or less the market value of your investable assets like IRAs, 401(k)s, savings accounts, individual bonds, etc.)

According to the RIIA, if your Consumption Ratio (Consumption/Financial Capital) is less than 3.5%, then you are overfunded and have bought yourself the flexibility to execute a low risk retirement strategy if desired. If your Consumption Ratio is between 3.5% and 7.0% then you are considered constrained in that you will probably have to either increase the use of annuities (which provide for periodic income payments), save more, or make living adjustments to achieve a low risk, sustainable retirement strategy. Our 20x ROT example would be considered "constrained" at 5% when using the Consumption Ratio framework.

If your Consumption Ratio is greater 7.0%, you are considered underfunded and need additional savings to reduce your dependency on risky investments to make up the shortfall. In many cases increasing your retirement savings investment risk (uncertainty) through heavy stock market participation is unavoidable, but you need to understand the trade-offs.

Finally, please remember to subtract any guaranteed income sources like expected Social Security, fixed annuities, or pension income from your annual Consumption calculation. This will improve your Consumption Ratio by offsetting part of your retirement living expenses.

Get Started with Our Retirement Calculator
In our practice, we like our clients to get "visual." This allows them to see where they are now to determine how much additional savings they need over their target accumulation period to reach an acceptable Financial Capital level that keeps their Consumption Ratio at least moderately constrained, if not overfunded. Thus, we created a simple, interactive retirement calculator that we share with clients and the public to help them determine their target portfolio value (Financial Capital) to keep their Consumption Ratio under 5%. To see how to use the Retirement Calculator, please watch our short help video.

Retirement Calculator Help Video
If you are interested experimenting yourself with the Retirement Calculator, you are welcomed to access it via this link: Retirement Calculator.

Please remember that there’s no inflation adjustment on the distribution (drawdown) calculation. In addition, all values are pre-tax even though your target Consumption amount theoretically incorporates an implicit tax expense. Nonetheless, after-tax cash flow is what pays the bills and more detailed tax planning as a next step must be incorporated to a produce more exact retirement savings number. Taxes and inflation will be subjects of future blog posts. 

Beware the Flaw of Averages
Rarely in life does an expected investment return match the observed (actual) return. Hence, the longer your planning horizon, the more uncertain the eventual outcome when growth is dependent on volatile assets like stocks. While our Retirement Calculator, along with the Consumption Ratio, will get you started on estimating how much you need to save now, Monte Carlo analysis is required to understand the probability of deviating significantly from your retirement plan assumptions. So, please go forth and start planning by calculating your personal Consumption Ratio.

About Jim Koch 
Jim Koch is the Founder and Principal of Koch Capital Management, an independent Registered Investment Advisor (RIA) in the San Francisco Bay Area. He specializes in providing customized financial solutions to individuals, families, trusts and business entities so they are better able to achieve their goals. Jim sees himself as an "implementer" of financial innovation, using state-of-the-art technology to provide practical investment management and retirement planning solutions for clients. 

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