How do you know if you can retire? It seems straightforward, but the answer is far from simple. Beyond portfolio balances and age thresholds, there are other things to consider. James explains his three-step test to determine your retirement readiness.
By pulling together principles from the 4% Rule, straight-line projection, and a Monte Carlo analysis, you can assess whether your portfolio can sustain your desired lifestyle over decades amid various market conditions. However, these tests alone don’t paint the complete picture. James emphasizes the importance of considering other assets like potential inheritances or property downsizing to more fully and confidently evaluate when you can retire.
Questions Answered:
How can I determine if I’m financially ready to retire?
Is the 4% Rule sufficient for determining retirement readiness?
Timestamps:
0:00 - Consider withdrawal rate
2:14 - 4% Rule
5:12 - Not a perfect strategy
7:39 - Straight line projection
9:09 - Downside of SL projection
11:07 - Monte Carlo test
13:07 - Understand severity of failure
16:20 - Defining success,
18:25 - Looking ahead
Create Your Custom Strategy ⬇️
How do you know if you can retire? It seems straightforward, but the answer is far from simple. Beyond portfolio balances and age thresholds, there are other things to consider. James explains his three-step test to determine your retirement readiness.
By pulling together principles from the 4% Rule, straight-line projection, and a Monte Carlo analysis, you can assess whether your portfolio can sustain your desired lifestyle over decades amid various market conditions. However, these tests alone don’t paint the complete picture. James emphasizes the importance of considering other assets like potential inheritances or property downsizing to more fully and confidently evaluate when you can retire.
Questions Answered:
How can I determine if I’m financially ready to retire?
Is the 4% Rule sufficient for determining retirement readiness?
Timestamps:
0:00 - Consider withdrawal rate
2:14 - 4% Rule
5:12 - Not a perfect strategy
7:39 - Straight line projection
9:09 - Downside of SL projection
11:07 - Monte Carlo test
13:07 - Understand severity of failure
16:20 - Defining success,
18:25 - Looking ahead
Create Your Custom Strategy ⬇️
How do you know when you can retire? Sounds like a simple enough question, but as you start to think about it, there's not really a simple answer. Is it when you have a certain portfolio balance? Is it when you turn a certain age or have a certain amount coming in from social security? All of these things are good, but even you take them further. Things like your Monte Carlo probability of success, things like a projection of how much money you might have at the end of your lifetime all of these things by themselves fall short if they're the only thing that you're looking at. That's why, in today's episode of Ready for Retirement, we're going to walk through the three-step test we'd like to go through to help clients understand when they're in a position to actually retire.
Speaker 1:This is another episode of Ready for Retirement. I'm your host, James Canole, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. So, as we jump in, the first thing that we really need to acknowledge is there's no perfect formula to guarantee success. As much as we want to rely upon numbers and projections and we want to think that we have an idea of what's to come. We can get close and we can make good, educated guesses, but, at the end of the day, there's no perfect formula that's going to guarantee success. Instead, what we need to do is we need to look at our retirement, we need to look at our portfolio and our plan's ability to sustain that retirement, and we need to do so from different angles. And we need to continue to revisit these things along the way to not only ensure that we can retire, but to ensure that we can remain comfortably retired. So we're going to walk through three things that you can do, as well as some bonus things that you can do, to make sure that you're in a position to answer the question can I retire? The first thing that I always like to look at is what is your withdrawal rate? So the first thing I always go to if someone says can I retire? Or hey, I'm already retiring well, I want to know what amount are you pulling from your portfolio? Your portfolio serves to create income for you, and what we want to know is can this portfolio create income not just this year, not just next year, but ideally for the rest of your life? Now, depending upon your life expectancy and how old you are. The rest of your life might mean something different to different people, but 30 years is a good starting point for most people who are retiring. So let's start with that 30 year number. What is a withdrawal rate that might be considered sustainable over a 30 year time period? You know someone's going to retire at 65 and maybe wants to ensure that their money is going to last potentially until their mid nineties, if that's how long they end up living.
Speaker 1:Well, this was the basis for the 4% rule. When Bill Banging created the 4% rule and wrote the white paper around that, that was the question he sought to answer. He wanted to see based upon any 30-year time period. So not retiring, assuming that, hey, you get great markets. That'd be easy If we knew the market was just going to go up. But you're going to have a really great market you're going to retire into. This becomes a lot easier.
Speaker 1:But the science is well, how much can you pull from your portfolio? Understanding that we have no idea what kind of a market you're going to retire into, but you know that you're not pulling out so much such that you might overextend your portfolio in the event that you retire and there's bad inflation and there's bad returns and things don't go according to plan. And that's where that 4% comes from. It comes from him testing many different time periods real time periods, time periods with really high inflation, time periods with really low returns and wanting to say what's the most we can pull from our portfolio and, by the way, he used a portfolio of 50% intermediate term US bonds and 50% large cap US stocks. He said what's the most that we could pull from this portfolio, adjust it for inflation and be sure that that portfolio is going to last for 30 years, regardless of the type of market environment you retire into. And that number came out to be about 4%. Now he had later revised that research and said look, if you also add some small companies into that, you can maybe adjust it up closer, about 4.5%.
Speaker 1:But that kind of serves as a good baseline to look at your portfolio and say, okay, if I'm going to retire, I'm going to have maybe some income sources from things like Social Security, Maybe I have a pension, Maybe I have some other type of income, but my portfolio, there's a limit to how much I can pull from that, while still being sure at least as sure as we possibly can be that that portfolio is going to last for me. So if you're retiring and you say, okay, I'm running the numbers, I'm going to have some money coming from social security. The rest I'm going to pull from my retirement account. And all of a sudden I start looking at what I pulled from my retirement account and it represents 7% 8% of my portfolio value. That's probably a sign that we should take a deeper look at that. There's some risk there that if that portfolio withdrawal rate is too high, your portfolio is not going to last you all the way throughout retirement. So that's the first thing you might look at. And, by the way, 4% or 4.5%, that's not even the be-all, end-all rule.
Speaker 1:There's other strategies of how you can take money out, but using something whether it's the 4% rule, whether it's a guidance guardrails type approach, where you can take more, at least based on their research, and as long as you follow more dynamic set of rules each year, take a higher amount out in your initial year of retirement and still be on track to be okay for the rest of your retirement, assuming in their research a 40 year time horizon for retirement. So that's a good starting point and I think conceptually that just makes sense of. Okay, if I retire and I don't take too much out of my portfolio, that as much as possible is going to ensure my portfolio is still going to be there for me. So my seventies, eighties, nineties, I'm still going to have money that I can live on. But it's not a perfect strategy.
Speaker 1:Here's why Most people don't just take one specific dollar amount from their portfolio and then adjust it for inflation the rest of their life. And this is because life doesn't happen that way. We have income sources that are going to vary, we have expenses that are going to vary, and just because you're withdrawing too high or even potentially much lower of a withdrawal rate in that first year of retirement doesn't mean it's going to continue that way forever. Here's a perfect example I just said well, what if you look at your withdrawal and it's 7% of your portfolio value or 8% of your portfolio value? Well, first blush you might say, well, I just can't retire. That's too high of a withdrawal rate. That's not sustainable to take that over the course of a 30 plus year retirement. Well, maybe.
Speaker 1:But what if you look at your numbers and say, OK, well, this withdrawal rate, this is me paying for a mortgage that's going to be paid off in a couple of years. And this is me paying for higher health care expenses because I'm not yet 65. But when I go to Medicare, those expenses will go away. And this is also me paying for part of my child's education which I'm only going to be paying for another one or two years. And what if I fast forward a couple of years and I'm on Medicare, my mortgage is paid off. I no longer have any support for children in college.
Speaker 1:Now, all of a sudden, my withdrawal rate drops to, say, 2%. Well, what does that mean? Does that mean when it was at 7% or 8%, you couldn't retire, but when it dropped, you could retire? No, that's just a part of normal life, of our expenses aren't going to be the same exact expenses every single year. Our income sources aren't going to be the same exact thing every single year.
Speaker 1:So when you start to understand that, then you can take that first test. And that first test is a withdrawal rate test. And I don't want to say, take it with a grain of salt, because it's absolutely a good test that you should run. But understand there's maybe some more nuance or some more perspective needed, in addition to that of not just what's our withdrawal rate that first year of retirement, but also, if possible and this is where software is really helpful project out what might it be in the fifth year of retirement, the 10th year of retirement, the 15th year of retirement. Because what that software can project out is well, what happens if you retire and maybe you aren't collecting Social Security yet? Well, you're taking a higher amount out of your portfolio, which is going to spike your withdrawal rate. What happens when Social Security kicks in? Well, now you're living on the same dollar amount, but you don't have to take quite as much out of your portfolio, so that's going to drive your withdrawal rate down.
Speaker 1:So, yes, the withdrawal rate test is good as test number one, but you want a big picture. And really, what that big picture looks like is really what is a straight line projection look like and really this is again where software comes into play of assuming a growth rate on your portfolio assets and assuming a year-by-year withdrawal rate from those assets. Does your portfolio projection look like it's going to continue growing or at least staying stable throughout your retirement, or does the projection show that you might run out of money 15 years in, 20 years, in, 25 years in. So what the straight line projection is going to show and you've probably all seen this is just hey, here's your initial starting portfolio value, and it's either growing or it's declining. It might go up and down along the way, but where does that end up if you live until 90 or 95 or 100? Not that that's actually going to be what's going to happen, because it's making some assumptions, not all of which are going to happen exactly as you assume them, but at least gives you a starting point of are we projected to be heading in the right direction?
Speaker 1:So this is the second test that you want to do to determine your retirement readiness. As does our straight line projection show that we're going to continue to have assets once we reach our expected life expectancy, or does it show that we're projected to run out at any point along the way? Now the downside of that and, by the way, each of these tests by themselves do have downsides. That's why it's important to look at this from multiple angles, because each angle brings its own perspective, brings its own benefit, but also, by itself, is somewhat limited. So when you start to combine them, you get a more complete view of your ability to retire.
Speaker 1:The downside or the limitations to the straight line projection is, as I mentioned. You're assuming a growth rate. Let's assume that growth rate is 6%. Well, what happens if you get 6% every single year and you take some money out to live on? Well, you might see that your projection looks really good until you start to realize you're never, ever, ever going to get exactly 6% every single year throughout retirement. We know this. That's not how the market works. So what happens when market downturns come into play?
Speaker 1:This introduces the concept of what's known as sequence of return risk. Sequence of return risk, says James. What if you get 6% throughout retirement? But the order in which you get those returns varies. So maybe you have James on the one hand, and James is retiring, and then another individual we'll call this individual John. John is also retiring, and both James and John get 6% from their portfolio over the course of their retirement. Well, first glance you'd say, well, they probably end up although it's being equal with the same ending portfolio balance. Well, not really Not if. What if?
Speaker 1:In James' case, he had a terrible go at it the first several years? So he retired in 2008, happened in his portfolio and his portfolio just went down, down, down for 18, 24 months or so before it started to recover again. Versus John. Well, John retired into a raging bull market and his portfolio balance just kept going up, up, up. So James had a horrible start to his retirement, but on the back end things really improved and got better, Whereas, let's say, John had a great start to his retirement and he had some lower returns in the middle or the back end of his retirement. Well, both of them averaged 6%. But because James retired into a terrible bear market and not only was the market dropping 20, 30, 40, 50%, but he was also pulling four or 5% per year from his portfolio balance, that really decimated his portfolio early on to the point that it never could really recover, and James actually ran the risk of running out of money because of that. That's sequence of return risk, and so what we want to understand is not just what if we get an average of 6% or 7% or 5% or whatever number you're projecting, but in what number of circumstances are you projected to actually be okay? This is the concept of a Monte Carlo test, and this is the third test that you should be running to determine if you can retire or not.
Speaker 1:Now, quick side note some people they begin and end with Monte Carlo. I want to be very clear. Monte Carlo analysis by itself is not a financial plan. Monte Carlo says here's your probability of success under all these assumptions and assuming all these things to be true. But it doesn't tell you what your withdrawal strategy should be. It doesn't tell you what your tax strategy should be. It doesn't tell you how much you can spend. It's really just saying, hey, you plug in the numbers and we'll give you an output. So it's helpful. It's a helpful gauge of your retirement readiness. But do not ever mistake that for the be-all end-all as a financial plan. I just say that because too many people do. They say, hey, I have a financial advisor, they give me Monte Carlo analysis every time I walk in. Well, how helpful is that really? Financial plans should tell you what to do. A Monte Carlo just helps you gauge the probability of success of those things that you should be doing.
Speaker 1:So the Monte Carlo test should be the third component of what you run when you look at your withdrawal rate. As okay, this is test number one. Do I have a sustainable withdrawal rate throughout my retirement? Test number two is a straight line projection of okay, I understand that my withdrawal rate is probably not going to be the same exact thing every single year. So if I run a projection, assuming some growth rate, do I still have portfolio assets at the end of my life expectancy? And then test number three is that Monte Carlo analysis of what's the actual probability of success. Taking 10,000 or a thousand different market returns or market environments of good returns, bad returns, everything in between, testing what percentage of the time would you have an acceptable outcome? No, one that you're not going to get. Just straight line returns of 5% every year, 6% every year, 7% or whatever it might be. So that's Monte Carlo.
Speaker 1:Now here's an add-on that I like to talk about. With Monte Carlo, Looking at the probability of success by itself isn't enough. You also have to look at the severity of failure. What do I mean by that? Well, let's say you have a Monte Carlo analysis that says, hey, James, you can retire and you have an 80% probability of success. Well, what most people hear is you have a 20% probability of failure. And failure, when you think about it, failure is not really an option. I can't fail at age 82 and run out of money because I can't go get another job at that point. So we want to make it really, really sure we don't fail. Well, let's define what failure means. Failure means you run out of portfolio assets in this case, and so the other component to the Monte Carlo test is understanding severity of failure.
Speaker 1:Let's go back to that example I just used If I have an 80% probability of success. But let's look at my actual situation. I'm going to make it up I want to spend $6,000 per month in retirement and I have $5,500 per month coming in from a pension, and then I've got some portfolio assets to fill in the difference. Well, I don't want to run out of that portfolio. That's what we're defining as failure in this Monte Carlo simulation. But worst case scenario if I do, the severity of failure isn't that significant. Yeah, I can't spend the full $6,000 per month that I wanted to, but I can still spend $5,500. So I'm not having to make some drastic life changes. Sure, I'm making some lifestyle changes, I'm cutting back on some things, but the severity of failure there isn't too dramatic. Now let's take that same example. But instead of having a $5,500 per month pension, what if I have a $1,000 per month pension and no social security and I still want to live on $6,000 per month. Well, now that severity of failure is pretty significant If I run out of portfolio assets. In that scenario, there's no way I can take $6,000 per month of expected living expenses and think that I could get by on just $1,000 per month. That is severe. That would require some really significant changes. Primarily, go get a job, because $1,000 per month that is severe. That would require some really significant changes. Primarily, go get a job, because $1,000 per month is not going to cut it. So that's where probability of success is helpful.
Speaker 1:At first glance, what's the probability that you'll still have assets left over at the end of your life expectancy? But take it a step further to say how acceptable is failure? In some cases failure is not all that bad because maybe you have something else that you can do, or it's not that much of a lifestyle adjustment. But that's another component that I would add to the probability of success component the Monte Carlo test. So those are the three tests. Number one is the withdrawal rate test. Are you withdrawing an amount that would be considered sustainable over the rest of your lifetime? Number two is a straight line projection of as we project out what the withdrawal rate looks like over the next 20, 30, 40 plus years. Do you anticipate, or do we anticipate, that you'll still have assets left over at the end of your life expectancy? And then number three is the Monte Carlo test. What is the probability of success here? And, to add onto it, what's the severity of failure?
Speaker 1:Now, that's not where we want to stop. That's kind of the first blush. That's the three-part test that we want to walk through. But I want to go back to what we talked about before of how are we defining success. Success is very narrowly defined in this. Success is do you have assets left over when you pass, or do you not? Do you run out of assets or do you still have a portfolio value left over?
Speaker 1:So that doesn't tell the full picture, because, yes, your 401k or IRA or Roth IRA, those are obviously really important, critical components of your financial plan, but that's not all there is. And so, if you look at this, this is where, with good financial planning, you start to look at those other details. What do I mean by that? Well, maybe you're in a home that you don't plan on being in forever. Maybe that home is valuable. Maybe you've got a million dollar home today and at some point you're going to downsize to a $500,000 home. Well, if that's not reflected in your financial plan, then it's not going to be taken into account when you're looking at Monte Carlo simulation. It's not going to be factored into the withdrawal rate test or the straight line projection test. So that's where you have to think ahead of okay, what other assets do we have? Maybe you sell this home in the future and that unlocks some liquidity. That unlocks some extra assets that you can use to fund your plan. So that's one example.
Speaker 1:Or what about an inheritance? Maybe you think there's an inheritance coming, but you don't know exactly what that's going to look like. Or maybe you do know exactly what it's going to look like. How would that impact some of these things? And I say this because a lot of people, when they're running their financial projections, they'll say, yeah, we probably have an inheritance coming. Maybe we don't know exactly what it looks like. Maybe we'll inherit our parents' property split evenly between siblings, or maybe it's a cash or retirement account, whatever it might be. But a lot of people will say, James, we actually don't want to include this in our base case plan. We want to run our planning projections just with what we have. The inheritance is something we don't really want to think about, it's just extra, that's totally fine. But just understand that that inheritance would impact your retirement readiness, Because if we look at this and say, hey, you're just not quite there, your withdrawal rates may be too high or the projection projection is not looking good, or your Monte Carlo probability is just lower than we'd want it to be.
Speaker 1:Understand that a potential inheritance this is obvious, of course, but just think of this an inheritance would change us quite dramatically. So how do we factor that in? What other windfalls might there be? What other things might happen? And so don't just look at your financial plan in this really incredibly myopic way of being too nearsighted, without looking at the big picture of, yes, look at the three-part retirement readiness test, but also understand well, hey, what could change? What could change if we downsize homes? What could change if we receive an inheritance? What could change if we ever went back to work at any point or did anything differently?
Speaker 1:Because there are different things that you can do to adjust this based upon what your financial planning goals are and based upon some of the circumstances that you're in as you start to work through that. So those are the three things that we like to look at to say how do you know if you can retire? Well, it's not just having a certain dollar amount in the bank, it's not reaching a certain age. It's not having a certain amount of dividends coming from your portfolio. It's running through these tests. Is your withdrawal rate sustainable? Does your long-term projection keep you on track? Does your Monte Carlo probability of success reach a high enough level that we feel comfortable saying yes, you're in a position to be able to do that. And then, are you taking into account other factors that could change that as well? So I hope that's helpful. That's what we do internally at Root Financial. I know that's not just the only way to do it, but it's a way that we think makes a lot of sense and I hope that's helpful for those of you who are listening to determine are you ready to retire and if not, now, what is the point at which that might happen.
Speaker 1:So, thank you, as always, for listening. I hope this was helpful. If you are listening on Apple or Spotify, I would really appreciate a review if you've been enjoying the show. If you're listening on YouTube. Make sure that you give it a thumbs up, make sure you comment and subscribe. If you want to have more episodes like this, come into your YouTube playlist once a week or so.
Speaker 1:That is it for today. Thank you for listening and I'll see you all next time. Hey everyone, it's me again. For the disclaimer, Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call with one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.