I am asked quite frequently how much you should have in your 401(k) when you retire. The real question is how much will I need to have to withdraw a certain amount of income from the plan when they retire. These seem like the same question, at least on the surface. Determining your eventual distribution from your plan depends on how much is in your plan.
The problem lies in an unknown future filled with financial events that are largely beyond your control. We can’t predict inflation. It could be mild as it is currently or it could skyrocket. We can’t predict taxes. They could remain stable and if the popular theory of being taxed less in retirement holds any validity, we can make educated guesses as to what that rate will be – but not much more. We can’t predict the markets. We tend to be an optimistic sort projecting past historic returns as a measure of future results.
So if inflation doesn’t cooperate and taxes could rise and the markets continue to be volatile, where does that leave us? And with what controls?
Let’s begin with inflation. For those of you who may not be aware of the effects of this negative impact on the worth of our dollar, inflation works as a sort of tax. You can count on it being there as the cost of living increases with the cost of producing the goods we need. The problem with inflation is how it is calculated. The CPI or Consumer Price Index does not include the two most volatile elements in our everyday lives: fuel and food. These could have the largest impact on a retirement plan as you begin to take your distributions.
How much of an impact remains to be seen. The safest bet is to assume real inflation will be twice as high as reported. If the CPI is 2%, you can expect that the real cost to your spending dollar would be around 4%.
A $2,000 monthly withdrawal from your 401(k) – requires over $275,000 returning 6% per year with an exhaustion time horizon of 18 years or age 83 – would actually be worth only about $16,000 a year at the end of that time frame. To keep pace with inflation, you would need to continually increase your distribution until it reaches about $30,000 at which point, at age 83, you would be broke.
You would still be taxed at your normal income rate based on the $24,000 annually but the real (spendable) dollars would be worth far less. So if you were to add in taxes with inflation, your real withdrawal rate would need to increase as well to offset the income tax rate. Not only would your accounts need to produce a steady return throughout those years but you would need to be withdrawing roughly $48,000 per year to achieve the same $2,000 a month income at the first distribution.
The last factor is market performance. This is even more unpredictable based on the events of the last decade. Historically, markets fall fast and recover slowly. The last ten years have pointed to similar patterns for losses but an over-accelerated recovery of less than five years. Can this be considered the new norm? Hardly. And if you think that your investments will recovery in kind with the markets, you would be greatly overestimating your skill as a retired investor.
The most common advice for those close to retirement or already there is to protect your investments from these sorts of events. This also limits your portfolio’s exposure to growth. Going conservative at too early an age could greatly jeopardize your retirement balance when you do stop working.
So here we are: invest too conservatively and you will not have enough retirement dollars to receive what you think you need; project too much into the market and you will withdraw too much too soon drawing down your portfolio in the process too early.
So what do we have control over? How much that income you eventually decide to take is allocated is yours and yours alone. How much debt will it service? How much mortgage remains to be paid? How much upkeep your personal property will require? And how healthy you are? How much you have in your portfolio? Each of these questions and their ultimate answers lie in your hands.
You can control the debt level you have if you begin now. You can enter into retirement with a paid-for mortgage leaving you the opportunity to possibly reverse that mortgage later in more difficult times. You can estimate property taxes, insurances and upkeep with a greater degree of accuracy than inflation, income taxes and the market forces. If you do, shoot high (estimate 30% over rest of your life is a safe assumption) and be pleasantly surprised by the savings if your estimates were too high.
You have some control over your health if you begin now and work at it. Arguably the hardest of the four questions that need to be answered but something worth working towards.
Your portfolio balance is left to you and you alone. If you haven’t increased your investment contributions and come close to 15% of your pre-tax income, you will most likely fall far short of your goals. If you don’t know what your goals are, here is the simplest one to adopt: assume you are retiring on the worst market day of the year and plan from there.
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