What lump sum would produce income of $70,000 per year you ask? One of the simplest formulas in finance is the calculation for an annuity in perpetuity. It is simply the sum you need divided by the return you feel your investments can generate. For a very conservative low risk portfolio, you might generate 6% per year. The formula would be $70,000/.06 = $1,166,667. So, to generate an annual income of $70,000 at a return of 6%, without spending principal, I would need to have $1,166,667 available when I retire.
If I had an average return on my portfolio of 8%, to generate the same income I would need $70,000/.08=$875,000 in savings. You get the idea. If you don't have that much saved up, you could spend down principal. You run the risk however of outliving your savings.
As an example, say you had saved $500,000 and could earn 8% on the portfolio. The portfolio would produce income of $40,000 per year with no spending of principal. To get to $70,000 per year, you would spend an additional $30,000 out of principal. The next year you would have only $470,000 to generate income and you would need to spend more principal. You would deplete your savings completely in 12 years.
That's bad news, since the average person who turns 65 in the USA this year will live at least another 20 years. So, you would run out of money 8 years before you ran out of life. Ouch! Be nice to your kids and hope that one of them is rich and generous.
In my next post I'll talk about how much you have to save to hit the savings bogey you set.
You state that if I need at least $70k per year in annual income to survive comfortably, and determine that I can comfortably generate only a 6% per year return in a conservative low-risk portfolio, without spending principal, I will need to have about $1.2mm available when I retire.
What about the negative effect of the cost of inflationary living and tax escalation over time? Even at a modest increase of 3% per annum, doesn't that add at least another $233k to the total savings required? (Actually, it's a good deal more than that, isn't it, if you take into account the negative effect of annual compounding?) And then by the time you also consider the ever-rising cost of health care and prescription medication required by a typical retiree, I would venture to guess that you're going to need something closer to a minimum of $2mm in some form of savings to provide for your comfortable retirement. (Although with that kind of total reserve, I don't particularly see why you should realistically worry about whether or not you prudently spend down some of your principal every year, as well, before you die. Nobody lives forever, and your children can amass their own fortune, without the benefit of a huge inheritance from you, which they just might squander away!)
Posted by: Bob Hansell | March 22, 2006 8:04 AM | Permalink to Comment