Friday, December 6, 1996
Foolish Retirement Planning
by MF DowMan

One thing most of us dream about is retirement, preferably sooner rather than later, too. So a question we naturally ask ourselves is how big will our portfolios have to be to sustain us indefinitely in retirement. Let's look at an example.

The first task is to decide what level of annual income (in today's dollars) you will need to maintain the lifestyle you want. Be realistic, though. If you expect your retirement income to be significantly higher than you ever earned while working, you may well never get there.

Let's assume a nice round number of $50,000. That's not Park Avenue, but if you own your home and are debt free, most of us could live quite well on $50,000 a year. If that's not enough, just adjust the figure to suit you.

To generate $50,000 a year comfortably, you will probably need a stock portfolio of at least ten times that much, or $500,000. With such a portfolio, you would need a 10% return to meet your annual spending needs. From someone who advocates the Dow Approach and its long-term track record of more than 20% gains, you're probably wondering why I'm suggesting you need such a big cushion. The reason is two-fold.

First, there's no guarantee the market will do well in any given period, so it helps to have a cushion in case the market under-performs. So, if you need to spend more than your 10% target in a year during a bad stretch, it's not devastating. When the market and your portfolio recovers, you should be able to recoup the shortfall in a year or two. Ideally, you would have an even bigger margin for down periods -- a plan, perhaps, to spend only 5% to 7% a year rather than the 10% I'm using in this example.

Second, you want to spend less than you expect to achieve in earnings so you leave room for portfolio growth. If your portfolio is growing at 15% to 20% a year and you're only spending 7% to 10% of the profits each year, you still have compounding taking place, which more than adequately covers inflation and gives you an even bigger cushion in future years.

Okay, so now you know what you want to spend each year in today's dollars ($50,000), and how much you need to sustain that allowance in today's dollars (a minimum of $500,000). How much will you need in future dollars to achieve that goal? Assuming a 4% annual rate of inflation, let's say you're starting with $10,000 and will achieve 20% returns using the Dow Approach. If you don't add another penny to your portfolio (a very UnFoolish thing to do), it will take 27 years and 5 months to reach the equivalent of a $500,000 portfolio in today's dollars (or $1.46 million in 2024 dollars).

Of course, you reduce that time until retirement each time you add to your portfolio over the years. For example, if you add $2,000 a year, the time until retirement shrinks from 27 years, 5 months to 22 years. If you add $4,000, you can reach your goal in 19 years.

So if your goal is to live on your investments, figure out how much you want to spend each year, multiply that by at least ten to get the required base portfolio in today's dollars, and then adjust that for inflation of roughly 4% a year to see how long it will take you to retire comfortably. With Foolish diligence, patience, and disciplined saving, you can get there from here. And when we all get there, let's meet for a drink in the 19th Hole. The first round is on you!