The Daily Dow
Thursday, October 16, 1997
by Robert Sheard
LEXINGTON, KY. (Oct. 16, 1997) -- Almost all investors will list as one of their goals the freedom to retire comfortably some day and live off of the proceeds of their investments. But trying to quantify what would be required for that goal to be realistic is sometimes difficult. In fact, financial planning software has been designed just to plan out such scenarios. As such a retirement is also one of my own goals, I've developed my own rule of thumb that anyone can use quickly to see what's possible. You don't need the fancy software or twenty-page printout from an expensive financial planner.
Let's call it the Five Percent Rule of the Twenty Factor. Here's the process, and prepare yourself, it requires some advanced math. Determine how much of an annual "salary" in today's dollars you need from your investments. This should include everything you need to cover during the year, including taxes. Now here comes the tricky math part. Multiply it by twenty.
Whew. Did I lose anyone? That's all there is to it. Multiply how much you need each year by twenty to tell you how large your portfolio needs to be to retire and live forever on your investments. (And I do mean forever. No one wants to run the race to see what runs out first, your life or your money.)
By having twenty times as much as you need in annual spending needs, you can survive down times in the market and not have to panic. Sure you're going to make more than five percent in long-term returns, but you have to have a cushion for down times and you need to make more from your investments than you withdraw for your "salary" because of inflation. If you just stay even each year, you ultimately lose to inflation, so growth has to be included in the equation.
Let's look at an example. If Sally and Mike decide they need $100,000 a year right now to retire indefinitely, their portfolio should be around $2 million (twenty times $100,000). If you need less, the portfolio requirement will be lower. The raw number isn't important in this example, only the ratio.
Using the returns for the Dow 30 since 1971 (which includes an ugly bear market early in the sequence), let's see how this plan would have worked for Sally and Mike. Let's also assume that they give themselves a three percent raise each year to account for the cost of living increases.
In year one, they had $2 million. They withdrew $100,000 for their salary and invested the rest. The return in year one was 9.06%, giving them $2,072,140 at the end of the year. So even though they paid themselves for everything they needed, their total portfolio value still increased.
At the beginning of year two, they withdraw their salary of $103,000 (don't forget their "raise"). The return in year two was 16.70%, leaving them $2,297,986 going into year three and the start of a two-year bear market.
At the start of year three, they still have to meet their expenses, so take out their $106,090 salary and invest the rest. But the market dropped 10.86% this year, cutting their total portfolio to $1,953,856. At this point, a lot of investors panic. After all, their portfolio is now lower than it was when they began three years earlier. On top of that, their expenses keep going up each year. But with the Twenty Factor built into their plan, they have some cushion and Sally and Mike are going to be fine.
Uh oh, the market got worse in the fourth year. After withdrawing their salary of $109,273, their portfolio lost an additional 16.91%. Ouch. That's a 26% drop in just two years, not long after they retired. What's going to happen to Sally and Mike's plans for that comfortable retirement? Their portfolio after four years is now down to $1,532,665.
But let's look ahead. The next year's salary of $112,551 still only represents 7.3% of their total portfolio and they've just weathered the worst bear market of the last quarter century. From there, the law of market averages takes over and their portfolio starts to grow again. In fact, by the end of the twenty-sixth year (1996 in real life), they're paying themselves a salary of over $200,000 a year and their total portfolio value has increased to more than $16 million. They're making significantly more in returns on average than the rate of inflation, so they're able to sustain -- even increase -- their cost of living while still seeing real portfolio growth. They can live on such a plan forever if they find the fountain of youth.
Having that cushion got Sally and Mike through an ugly market unscathed, even though their retirement couldn't have been timed much more unfortunately. And just think how they would have fared if they had invested even more Foolishly. If you substitute the returns for even the most conservative of the Dow Dividend Approaches (the High Yield Ten) instead of the returns for the entire Dow 30 I used in this example, Sally and Mike would have done far better. Instead of a mere $16 million after the twenty-six years of retirement, Sally and Mike would have nearly $71 million using the same scenario. Obviously, they could increase their annual salary dramatically and still enjoy considerable growth through the course of their retirement years.
You might be able to retire on less than twenty times your spending needs if you're lucky enough never to have any major market downturns, but it's nice to know that with the Five Percent rule, you're even reasonably protected against them. And it gives us all a tangible portfolio goal. So don't plan your retirement based on your age, base it on the Twenty Factor. You can retire whenever you get there, whether that's at age 40 or age 70. Start early and Fool on!
Rankings Note: After SEARS' <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: S)") else Response.Write("(NYSE: S)") end if %> earnings announcement today, the stock dropped enough to replace UNION CARBIDE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: UK)") else Response.Write("(NYSE: UK)") end if %> as the #3 stock in our current rankings.
(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool. ________________________________
Stock Change Last -------------------- T -1 3/16 43.75 GM - 3/8 70.00 CHV - 11/16 86.00 MMM -2 1/16 95.56
Day Month Year
Day Month Year
FOOL-4 -1.64% 2.06% 18.56%
DJIA -1.48% -0.08% 23.12%
S&P 500 -1.09% 0.84% 28.96%
NASDAQ -1.38% 0.83% 31.65%
Rec'd # Security In At Now Change
1/2/97 153 Chevron 65.00 86.00 32.31%
1/2/97 179 Gen. Motor 55.75 70.00 25.56%
1/2/97 120 3M 83.00 95.56 15.14%
1/2/97 479 AT&T 41.75 43.75 4.79%
Rec'd # Security In At Value Change
1/2/97 153 Chevron 9945.00 13158.00 $3213.00
1/2/97 179 Gen. Motor 9979.25 12530.00 $2550.75
1/2/97 120 3M 9960.00 11467.50 $1507.50
1/2/97 479 AT&T 19998.25 20956.25 $958.00
CASH $1167.51
TOTAL $59279.26