Most retirement planning is done with complicated software. Unless the user is highly trained both on the software and with math and investments, mistakes frequently occur and go unnoticed. Making a mistake when building a software-based financial plan is extremely easy to do. While software can produce excellent retirement planning illustrations, investors embarking on retirement planning should also build a common-sense financial plan. What I call a common-sense financial plan does not require any software, can be drawn up on ½ a sheet of paper and is highly effective. A common-sense financial plan is a safe way to reconcile a complicated software based financial plan.
What is a Common Sense Retirement Plan?
A common sense retirement plan is a simple method for determining how much capital you need to retire and what risk score is associated with your spending strategy.
To build your own common sense retirement plan, follow this simple process:
- Set a retirement income goal.
- Subtract your social security benefit from your retirement goal.
- The remainder will be the distribution necessary from your portfolio.
- Divide the distribution by the percentage that equals your risk tolerance.
- 3% Conservative
- 4% Moderate
- 5% Aggressive
- The calculation will tell you how much money you need to retire.
Example Common Sense Financial Plan
In the table below, a couple planning for their retirement would like to have $150,000 in retirement income. They anticipate receiving $80,000 a year in social security. Therefore, they need to take $70,000 a year from their retirement portfolio. If they are conservative, they would divide their $70,000 portfolio distribution by 3% and that means they need $2.3m to retire. If they are moderate, they would divide their $70,000 by 4% and that means they would need $1.75m to retire. If they are aggressive, then they would divide $70,000 by 5% and that means they would need $1.4m to retire.
Back Test of The Common Sense Retirement Plan
In the charts below, we are looking at illustrations for the conservative, moderate and aggressive portfolio values, back tested over the last 26 distribution years. For each illustration we are using the same investment, the Vanguard Balanced Index Fund, Admiral Share Class. This fund is a popular retirement fund with a 60/40 equity/fixed asset allocation. Each illustration has the same start date of January 1st year 2000. Distributions are annual. All three illustrations have the same annual inflation adjustment of 3%.
Conservative Risk Common Sense Retirement Plan
Moderate Risk Common Sense Retirement Plan
Aggressive Risk Common Sense Retirement Plan
The three illustrations incorporate both bad timing and sequence of negative returns risk. For a person who retired in the year 2000, they retired at a tough time, right before a recession. The years 2000, 2001 and 2002 were all negative return years for the S&P 500. The three sequential negative return years add additional stress to the retirement portfolio. Despite bad timing and sequence of negative returns, the 3% and 4% illustrations were doing fine after 26 distributions. The 5% aggressive distribution, however, had run out of money.
Use this simple retirement planning technique to quickly determine if your complicated software-based retirement plan makes sense or not.
Ethan S. Braid, CFA
President
HighPass Asset Management
Your broker or advisor will charge you fees or commissions to make investments and therefore your returns will be less than indexes. For example, if you invest in the S&P 500 ETF, SPY, you will pay a fee to the company managing the ETF, State Street Global Advisors. Your return on the S&P 500 ETF, SPY, will be less than the S&P 500 Index TR because of the fee paid to State Street Global Advisors. Additionally, you may pay a fee or commission to your broker or financial advisor, further reducing your return, below the index. Consult your advisor or broker for a detailed list of their fees or commissions before you invest. Investing involves risk and you can lose money.