Your response to Alan from Iowa really posed the question “How much money do I need to have saved up in order to be able to live off it for the rest of my life, and what return do I need?” I think I’ve stumbled on a simple way to figure this out. You just start out with an adequate nest egg and make sure that your investments return at least double the rate of inflation that you’ll experience over the remainder of your retirement life. That way you can use half the return on your investments to live on, and re-invest the other half, in order to keep your investment funds growing at the same rate as inflation.
It works like this: Suppose you want to live on an annual income of $50,000 for the rest of your life, adjusted for inflation, and you think inflation will average 4% over your lifetime. To determine the initial nest egg you’ll need, divide 100% by 4%, which gives you 25. Multiply that by the $50,000 you want to live on — your starting nest egg must be $1,250,000. If your starting nest egg yields double the rate of inflation, that is, 8%, it would give you $100,000 the first year. You would live off half and re-invest the other half, which would increase your investment “pot” so that it would keep up with inflation.
One can argue about whether inflation will grow on an average of 3%, 5% 7%, or heaven forbid, more. But as long as your investments return double the average rate of inflation, you’ll never outlive your money before you die.
Where’s the flaw in this picture?
Well, it’s a little like the advice for becoming a millionaire. (“Step 1: Get a million dollars.”) As long as you can earn, after-tax, double the rate of inflation, you’ve got the makings of a nice retirement.
But your formula is unlikely to win a Nobel. Say you expected 2% inflation. You’d then need twice as much to retire (dividing 100% by 2% gives you 50, multiplied by $50,000 equals $2.5 million), when in fact lower inflation should make it easier, not harder, to retire comfortably. (If you expected 1% inflation, you’d need $5 million. At zero inflation, you’d need all the money in the universe.)
The higher the inflation rate you assume, the lower the nest egg your formula tells you you need — and the higher after-tax return it tells you you must earn. Yet in a high inflation environment, it’s often not possible even to match inflation, after tax, let alone double it. So your formula is sort of backwards.
The biggest flaw the Nobel judges will flag, of course, is that none of us can predict long-term inflation rates.
But on one fundamental point you are right for sure: You can’t spend all your investment income and still expect it to keep up with inflation. Unless you have a date with a comet and know exactly when you’re going to pass from this earth to a higher place, “live beneath your means” applies at least as strongly after you’ve retired as before.
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