Many people want to retire but aren’t sure if they can. Americans like our round numbers, so a common question they pose is, “Can I retire on $1 million?”
The quick and easy answer is “Yes.” The more nuanced answer is, as always, “It depends.” What does it depend on? It depends on your success in protecting your retirement portfolio from unjust losses and taxes. It can be challenging to outgrow inflation, taxes, legal clawbacks, and market crashes.
It also depends on your burn rate (i.e., how much you spend). If you withdraw money too quickly from your portfolio, regardless of your investment or tax mitigation strategies, you increase the unfortunate odds of running out of money in retirement.
Although inflation has rendered the $1 million retirement savings level less of a status than it used to be, according to a CNBC/Survey Monkey survey, just 16 percent of retirees have more than $1 million saved.
How much do you need to spend during retirement?
Some financial advisors say that a good rule of thumb is to plan on spending about 80 percent of your pre-retirement income per year during retirement. However, that doesn’t account for two critical things. First, people don’t like to cut their standard of living by 20 percent. Many people would feel it if their paycheck was cut by one-fifth. Second, healthcare costs increase significantly after we stop working because we typically retire at a later age, when medical costs increase.
Fidelity Investments’ 23rd annual Retiree Health Care Cost Estimate revealed that a 65-year-old retiring today can expect to spend an average of $165,000 in healthcare costs and medical expenses throughout retirement. Double that for a couple; that represents nearly one-third of a $1 million retirement portfolio.
The estimated healthcare spending assumes enrollment in Medicare; however, choosing the right coverage is easier said than done, so I strongly advise working with an experienced professional when selecting Medicare plans. I can see how that comment may sound self-serving since I own a financial services company; however, I am the first to say that most investors would do just fine buying an S&P 500 Index fund, never looking at it, and never hiring someone like me for investment selection. I call balls and strikes as I see them; you should talk to a professional when it comes to filing for Medicare. (That professional does not need to be a financial advisor but should be someone who consults and implements filing for you and doesn’t just give you a website address. This stuff can be tricky. A free service is the Serving the Health Insurance Needs of Everyone, SHINE, Program.)
How to create income in retirement: Social Security
Social Security will help you replace your income before touching your $1 million portfolio. The maximum monthly Social Security benefit per worker is about $3,822 (based on full retirement age; delayed credits could increase the amount). For a two-person household, the maximum annual payment is about $91,000. That’s pretty darn good! To achieve that yearly payment, however, a retired couple was probably making $352,000 per year (based on the Social Security salary cap rate). That would leave them nearly a quarter million dollars short of maintaining their pre-retirement lifestyle (and that is before those increased healthcare costs). An uninvested $1 million portfolio might only last four years; a couple retiring in 2025 could burn through their million-dollar portfolio by 2029.
Again, that is if the maximum Social Security payment is secured at full retirement age. The average is about $1,925, or half the maximum. Making it worse, for many people, 85 percent of Social Security benefits are taxable at ordinary income rates. This means that careful timing and planning are significant to a retiree.
How to create income in retirement: Withdraw from your investment portfolio
There is a heuristic known as the “Four Percent Rule.” I don’t necessarily subscribe to it, but since we are not writing a customized financial plan for you here, it is good enough for now, especially if you are a conservative investor with limited exposure to the stock market.
The Four Percent Rule says that withdrawing four percent of your portfolio value in the first year of retirement and adjusting that figure for inflation would sustain a household’s investment portfolio’s value in retirement. That is $40,000 annually from a $1 million portfolio (not adjusting for inflation).
Adding $40,000 of income from your portfolio to the maximum Social Security benefit ($91,000 per year) gets you to about $131,000 of income per year. But just as you can only count on that Social Security income if you time, plan, and file it wisely (and correctly), you can only count on that four percent if the stock market doesn’t tank as soon as you retire. Financial advisors refer to that phenomenon as a “sequence of return” risk; a 20 percent decline hurts more in Year One than it does after Year Five or Ten.
If the amount of income that your portfolio can create is not a wide margin above your burn (spend) rate, it may be prudent to prepare for market volatility soon after retirement. To be clear, I do not endorse the common practice of new retirees to shift from what may have been considered a “growth” portfolio to a long-term “conservative” portfolio. For many people, there are still decades of investing/living to be had after retirement, which gives time to invest for growth. Also, any remaining assets are often bequeathed to heirs, which extends the investment horizon of the portfolio. However, just as a good offense can be the best defense in sports and business, a good defense (volatility control) can be the best offense (increasing income) for a new retiree.
Paying attention to the sequence of return risk could allow you to jump from a four percent withdrawal rate to a six or eight percent rate or more (depending on investment returns, which will depend, in part, on your equity allocation).
Many retirees have done a great job investing up until retirement because they focused on the long term. However, protecting the portfolio from the first big market crash after retirement (especially if that crash occurs soon after the retirement date) is critical. Assigning some hedges that allow for appreciation, like so-called “buffer funds” or selling out of suitable long-term investments with short-term risks, can be a good way to control how much income a retiree can withdraw during a market crash. Then, after the crash, the investor can use that opportunity to realign the portfolio’s allocation to be more growth oriented.
Spend what you want; just don’t spend it at the IRS (Internal Revenue Service)
Selling appreciated equity after protecting it from a market crash can create a stream of favorably taxed income for the retiree (a 15 to 20 percent capital gains tax rate). There is no need to rely on the partially outdated practice of tax-inefficient dividends (up to the 37 percent income tax rate). In that same vein, be sure to withdraw the proceeds in the most tax-efficient manner. (Tax-efficient decumulation could be an entirely different article or even a book; I will write something about this in a future article.) Proper withdrawal planning could save a retiree tens of thousands of dollars per year.
Excess withdrawals in the first years of retirement are common but threaten income sustainability. I am not a proponent of budgets—I am, however, a fan of planning. If a retiree wants to spend $100,000 above their income needs in the first couple years of retirement, go for it! But let’s modify the spending plan to account for it so that we can, in a sense, give you permission to stop working without the fear of running out of money in retirement.
The million-dollar summary
- A $1 million investment portfolio can provide $40,000 (Four Percent Rule, before taxes; not inflation adjusted to $80,000, with sequence-of-return protection).
- Social Security maxes out at $91,000 per year for a couple (this is possible if their combined income was $352,000 per year before retirement). Get advice on maximizing payments; don’t make the amateur mistake of simply defaulting to waiting as long as possible to begin receiving benefits.
- Medical expenses can reach $165,000 throughout retirement per individual retiree. Seek a Medicare filing professional.
- It is OK to overspend if you plan for it, but otherwise, maintain your standard of living and control expenses (avoid expensive annuities and being overinsured, and stay healthy!).
- Invest your portfolio, but avoid market crashes, especially in the early years of retirement.
- Avoid taxes by using exchange-traded funds, placing the right investments in the proper accounts, and making tax-efficient withdrawals.
Bonus: Some of the key findings from the CNBC/Survey Monkey survey
- Illness and declining health are the top concerns for retirees, but financial worries are also significant. Over half (56 percent) expressed concern that their savings might not last throughout retirement.
- Nearly all retirees depend on Social Security payments, while high savers supplement their income with passive income sources, savings, and retirement plans.
- Four in 10 (40 percent) American workers are behind on retirement planning and savings, primarily due to debt, insufficient income, and getting a late start.
- Women are more likely than men to feel disappointed with retirement (23 percent vs. 17 percent).
- Nearly one in 10 (eight percent) people say they retired at an age later than they wanted; 49 percent say they retired at the age they wanted.
- Nearly three quarters (73 percent) of workers say that their personal retirement plans will look “very or somewhat different” from those of their parents, a pattern consistent across workers of all age groups.
- Nearly half (52 percent) of workers plan on working in some capacity after retirement, either because they need to supplement their income (27 percent) or because they want to work (26 percent). Only one in 10 (11 percent) workers have no plans to work after retirement; 36 percent say they are unsure.
- 47 percent expect to travel in retirement.
- 47 percent anticipate pursuing hobbies and interests in retirement.
Allen Harris is an owner of Berkshire Money Management in Great Barrington and Dalton, managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
