Retire with 3 million?

Headline – A couple tried to retire with 3 million – and it wasn’t enough! You often hear or read these kinds of stories. And it’s often a question of whether the capital sum they had managed to accumulate was enough under the economic circumstances, in other words giving the combined effects of inflation, interest rates, and stock market returns.

I stumbled on one like this a few weeks ago and quickly read through the account of a couple in their thirties, living in San Francisco, who set themselves up to retire with 3 million – actually it was about 3 and a half million. They both had high powered high salary jobs and they thought they had done their calculations. But about five years later after retiring in their mid-thirties, they had to go back to work… because …

and this could be where we start playing … spot the mistake …

… because of low-interest rates, the income from their capital didn’t match their outgoings.

So was this an honest mistake, did things just not turn out how they thought or had hoped … had they read this earlier article on how much money they need to retire … or had they just followed some Bad Investment Advice?

It all sounded so reasonable

The story goes that this married couple added up all their commitments, all they needed to live on an ongoing basis including health insurance, emergency funds, and enough for vacations, other travel and a few other luxuries. They already owned their home so they didn’t have to bother with mortgage repayments.

They worked out that the needed about $170,000 in pretax income per year and they worked out that with a conservative rate of return of 5 percent this meant they would need a capital sum or 3 and a half million dollars working for them.

Sinking interest rates, diminishing returns

But then five years later they found they could no longer get a steady and guaranteed stable 5 percent return with safe government bonds and they didn’t want ot move into riskier investments.

Living in one of the most expensive cities in the country couldn’t have helped and moving away wasn’t something they wanted to consider. Now instead of 5 percent returns and $170,000 pretax income or slightly more, they were only able to get around 4 percent which was grossing $140,000 before tax. They also didn’t want to eat into their capital …

So they went back into the workforce.

Investment horizon.

So what is wrong with this picture?

It’s all a matter of choice really. They made their choices for their own reasons and that’s all good for them. But on the face of it there is an opportunity missed.

One of the first things they should have considered is that in your mid-thirties you still have an investment horizon of 50 years or more. With that investment horizon, they should have been  – I would argue – at this stage fully invested in the stock market. A conservative approach to stock investing would be under these circumstances a managed investment fund linked to the Standard and Poor’s stock index..

Why the Standard and Poor’s and not the Dow Jones or the Nasdaq? The Standard and Poor’s is the usual shorthand for the Standard and Poor’s 500 index. The index tracks the share prices of the 500 largest US-based stocks, weighted by market capitalization.

And weighted by market capitalization just means that price fluctuations of the companies with the largest market capitalization affect the index more than similar price fluctuations of the companies with smaller market capitalization. This article explains more about market capitalization.

The Dow Jones 100 does much the same for the 100 largest companies and the Nasdaq composite index does much the same but only for companies listed on the Nasdaq exchange which includes many small and micro capitalized companies. History shows that the Standard and Poor’s 500 index is the more broad-based and stable indicator of what the stock market is doing. We’ll look at the long-term performance of the Standard and Poor’s shortly.

Factoring inflation

One of the most important considerations with such a long investment horizon is that you will need to ensure your capital to grow at a rate that matches and certainly in the first 25 of those 50 years outpaces inflation.

In the second half of that 50 year period, you could afford to slowly eat into your capital unless you want to leave a large legacy for family or other dependents.

Let’s say inflation is running at 2 percent a year. Depending on the consensus on where inflation is going and there are many market indicators or pundits that can tell you this, you might want to set aside 2.5 percent a year for capital growth to stay ahead of inflation. But I would check this every year and increase it if actual inflation inches close to that 2.5 percent.

So, let’s say you have your 3 and a half million. The Standard and Poor’s Index has averaged an 8 percent annual return from 1957 to 2018 and varies over other periods as we will see later.

Going back to the example of the San Francisco married couple, they were looking for a pretax income of $170,000 a year. Simple – they take the 5 percent return leaving a half percent buffer if the market doesn’t quite perform in the first year.

Once they have passed the first few years, their capital would have grown beyond where they safely needed it to be.

Did you spot the mistake?

This time it was my mistake and would rightly qualify as another piece of – Bad Investment Advice!

Implied in the statement above is the idea that a half percent buffer in a first-year investing in a Standards and Poor index funds would be enough against poor performance.  Anyone who has owned stocks would know that is a wildly optimistic approach.

The chart below shows the Standards and Poor year on year return from 1974 to 2019.

The blue line in the chart is the annual return. As you can see it’s pretty much all over the place. Over this period there were annual returns in excess of 30 percent gain in 1975, 1980, 1985, 1989, 1991, 1995, 1997, 2013 and 2019.

That means that a portfolio of stock that mimick the Standard and Poor’s 500 index would have increased in value by more than 30 percent in those years.

But there were also bad years. Between 1974 and 2019 there were nine years when that same portfolio of stocks would have lost value. And some of those years the losses were substantial, the worst being 2008 a loss of 37 percent, 1974 a loss of 26 percent and in 2000 a loss of 11 percent.

As we can see things look better if you average the returns over longer periods. The dark orange line shows the average returns over the previous five years. It stays mostly positive, but even over five year periods in this same time window from 1974 to 2019 returns can be negative or close to zero. It is only when we extend the window to ten years that it stays positive, that is the yellow line. Only the darker red line which is the 15-year average stays comfortably positive and above inflation.

Back to our couple

So how does all this relate to our San Francisco couple trying to build a pile of money to retire. Well, they were still in their 30s and both were highly paid. Let’s say they took 15 years to build their nest egg and they retired in early 2020. The average return of the Standard and Poor’s over that 15 year period was 10.47 percent which was actually 2 percent lower than the average over the whole period from 1974 to 2019 we looked at earlier.

There are many ways they could have built that 3 million dollar pile but let’s imagine they started with a gift of $100,000 and were able to save most of one salary at say $6,000 a month. Here’s what that would look like.

In this case, after that 15 years they would have ended up with $3,190,904.

If they hadn’t had $100,000 to start but still wanted to build their capital in just 15 years. In this case, they would have to find $7,000 a month to put in their savings plan. As the chart below shows.

And in this case, their nest egg at the beginning of 2020 would be $3,298,569

Shifting balance and shifting behavior.

In the case it would make more sense to build the capital further to 5 or 6 million and then as they advance through their investment and payout period, it would make the most sense to shift gradually away from stocks and into bonds. There are all kinds of rules and best practices like a 60/40 percent stocks and bonds balanced portfolio and that people in retirement can use 4 percent of their capital every year to use it up over their retirement years.

But more about all that another time.

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