Summary: Figuring out how much money you need to save up to retire looks like an impossible task. It seems like you'd need to somehow foretell the future - how long you have to live, your investment returns (especially the early years), your future cost of living, any major health or ageing costs, the extent of pension income you'll qualify for, changes to superannuation or tax, and other uncertain expenses or windfalls (assisting your kids, inheritance).
Yet, American financial independence and early retirement gurus - like Mr Money Mustache - have apparently simplified things: 50/50 stock-bond investment returns after inflation will reap about 5%, the safe withdrawal rate is around 4%, and your time to reach retirement depends solely on your savings rate (savings as a % of after-tax income).
For example, if you and your partner can live off $40,000 a year, then you need 1 million dollars in combined savings before you retire if you wish to be entirely self-funded (40,000 / 0.04). Many Australian pensioner couples who own their own home live off the government pension of $34,382 a year for a couple with virtually no other income. If wholly self-funded this would require $860,000. Given you can access part of the pension and top up your income with tax-free income from retirement superannuation accounts, it's easy to see, in principle, how achievable a comfortable retirement can be for most Australians (though those with less wealth may have to settle for renting when
But do the estimates based on American investment returns hold up for Australia? And do they rely too much on future returns being similar to past returns? How much buffer do you need to add if you prefer lower risk (thus lower return) investments? If you may need your savings to last a lot longer than 30 years, is Mr Money Mustache correct that "above 30 years, the length of your retirement barely affects the safe withdrawal rate calculations." And how does one factor one's actual future costs of living as opposed to a simplistic economy-wide inflation statistic?
In this post, I will attempt to provide short answers to questions like these as well as useful links for further reading.
My Situation: I can comfortably live off $25,000 a year (including rent). I actually spend around $30,000 a year when big-ticket discretionary spending like travel is included. My investment income is reliably over $30,000 a year now, so I obviously built up a buffer to eliminate all worries over whether I have enough wealth.
Most people aren't suited to pursuing the extremes of financial independence. The aim is to have enough wealth to maximise your quality of life when it counts - while you're young and healthy enough and have family and friends around.
Details:
1. What do the most popular American bloggers say about retirement calculations and the amount of savings needed?
The most quoted blogger on retirement maths is Mr Money Mustache and his key posts are below:
Mr Money Mustache
> The Shockingly Simple Math Behind Early Retirement
> The 4% Rule: The Easy Answer to “How Much Do I Need for Retirement?”
However, the most accurate advisor on the complexities and considerations for figuring out how much you need to retire is the Financial Mentor.
Financial Mentor
> The Truth About Retirement Income & Dave Ramsey’s Shocking ROI and Safe Withdrawal Rate Assumptions with Wade Pfau
> > Posts tagged "retirement planning"
2. What is the safe withdrawal rate (SWR) and what are the key considerations for early retirees?
While the calculations are only applicable to Americans, the best, concise explanation - especially for those retiring early - is below:
> Mad Fientist - Safe Withdrawal Rate for Early Retirees
Conclusions:
- The 4% rule is actually very safe for a 30-year retirement
- A withdrawal rate of 3.5% can be considered the floor, no matter how long the retirement time horizon, so don’t jump on the dividend bandwagon just so you can avoid selling shares during retirement
- The sequence of real returns matters more than average returns or nominal returns
- The real returns during the first decade of retirement are most predictive of withdrawal rate success
- When you’re about to retire, take a look at the Safe Withdrawal Rate indicator to see an approximation of the current SWR
- After retirement, remain flexible, embrace challenges, don’t stress out about things you can’t control, adjust spending when necessary, and enjoy life
3. Does the 4% safe withdrawal rate apply to most countries including Australia?
No, it actually varies a lot; principally because returns from stocks and bonds over 30 year periods have varied a lot between countries. The U.S. actually has the highest SWR, so 4% should not be used as the benchmark. On the other end is Japan with a SWR of 0.26%! Australia has an SWR of 3.5%.
To see the difference changing the SWR from 4% to a lower figure makes just do the simple division:
Wealth Required = Retirement Spending / Safe Withdrawal Rate
For retirement spending of $40,000/year:
United State Wealth Required: $40,000 / 0.04 = $1,000,000
Australia Wealth Required: $40.000 / 0.035 = $1,142,857
Japan Wealth Required: $40,000 / 0.0026 = $15,384,615
Clearly, few people would be confident retiring early and investing wholly in Japanese stocks and bonds. Obviously, you can invest in foreign markets - indeed a Japanese retiree could put all of their money into the U.S. market - but you would have to deal with significant currency risk as well as higher fees and less tax advantages.
Also, you might not have full control over investing some of your retirement savings in foreign markets. For example, Australians using superannuation funds will have most of their stock exposure in Australian stocks.
A more recent and detailed analysis on SWR for Australians is below:
Morningstar
> Safe withdrawal rates for Australian retirees
Findings from analysis between 1900 and 2014 include:
- The true safe withdrawal rate varies significantly by country and target success rate. For example, using the historical returns in Japan a 95 per cent target success rate would yield an initial withdrawal rate of 0.2 per cent versus 3.0 per cent for Australia.
- The 20-country average was 2.29 per cent.
4. How does stock market concentration (country, sectors and companies) affect how one should invest?
See: Morningstar - Safe withdrawal rates for Australian retirees
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Looking at the different weights to various industries in domestic and global share markets, it can be clearly seen that the Australian market is highly concentrated to financials (inclusive of real estate) and materials.
The defensive sectors - utilities, energy, telecommunication services, health care and consumer staples - are not well represented domestically. Adding defensive stocks reduces cyclical bias and has the benefit of cushioning returns in down markets. Diversification is a key tool to reduce the impact of wealth shocks.
It is also worth noting that in addition to sector concentration, the Australian share market also exhibits issuer or security-specific concentration. The top 10 stocks made up approximately 48.9 per cent of the S&P/ASX 300 index as of 31 October 2015.
Importantly, many investors have come to recognise the importance of overseas diversification in equity portfolios and the exposure has been gradually increasing. Today, the typical superannuation fund has an approximately equal split between Australian and international equities.
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5. What is the tradeoff between certainty of your savings lasting and the maximum SWR for Australians?
If risk averse you could keep all of your savings in government-backed term deposits and settle for safe but low returns resulting in a low SWR and thus requiring a larger savings lump sum to retire. The more risk you are willing to take that your savings will run out the higher the SWR as your asset allocation to stocks can go up.
Morningstar's Australian-specific research produced the below graph of the certainty versus SWR tradeoff. As you can see the SWR goes up considerably as risk tolerance (and equity exposure) increases.
6. How does the retirement period affect the SWR?
Of particular interest to early retirees is the impact of changes in the retirement period between say 20 years, 30 years, 40 years or 50 years.
Morningstar's research for Australians resulted in the below chart of the impact.
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- At the 70 per cent probability level, increasing the retirement period from 20 to 30 years reduces the withdrawal rate by approximately 26 per cent (5.7 per cent to 4.2 per cent).
- Similarly, the probability of success for a 4 per cent initial withdrawal rate is 99 per cent for a 20-year period, 78 per cent for a 30-year retirement, and 46 per cent for a 40-year retirement.
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Clearly, for Australians, Mr Money Mustache is wrong in asserting that: "above 30 years, the length of your retirement barely affects the safe withdrawal rate calculations."
However, it is clear that the curves get closer together for every additional 5 years and at some retirement length, the SWR impact will become quite small. Based on the Morningstar analysis, I'd argue that period for Australia is more like 50 years than 30 years.
It's also worthwhile reading the Longer Time Horizon section here but keep in mind it applies to U.S. data: Mad Fientist - Safe Withdrawal Rate for Early Retirees
Quite a few researchers have looked into how longer time horizons affect the SWR and Kitces describes some of their conclusions: “increasing a time horizon from 30 years out to 45 years reduced the safe withdrawal rate from 4.1% down to 3.5%”. He goes on to say that, “it appears that the safe withdrawal rate does not decline further as the time horizon extends beyond 40-45 years (given the limited research available); the 3.5% effectively forms a safe withdrawal rate floor, at least given the (US) data we have available”
So why doesn’t even longer time horizons result in lower SWRs?
Kitces explains... over long time horizons, even balanced portfolios generate returns significantly higher than 3.5%, and consequently the primary constraint of safe withdrawal rates is just having a withdrawal rate low enough to survive an early 1-2 decade stretch of poor returns. If the withdrawal rate is low enough to survive the first two decades of bad returns, then eventually the good returns arrive, the client recovers and gets ahead, and adding more years to the time horizon is no longer a risk.In my view, the major assumption here is that as long as you are investing at least 50% of your portfolio in stocks, then, in the long run, stocks returns will inevitably build a sufficient buffer such that your portfolio can last forever.
So you have to invest at least 50% in stocks. Stocks have to perform similarly in future to the past with total returns above inflation of at least 4-5%. And you need to avoid suffering a major setback during the critical first 10 years.
7. What about the Australian government pension?
Like most blogs about financial independence/freedom and early retirement (aka FIRE), this post ignores government welfare and assumes all retirement income will be from your investments alone. If seeking full financial freedom, government welfare should at best be seen as a safety net to catch you should really bad luck strike - such as terrible investment returns, poor health, or a family emergency. (Government-regulated retirement income that is directly linked to your contributions - known as superannuation in Australia - should be included. See below.)
In the 21st century, government pensions and overall assistance for seniors (health, aged care, rent and utility benefits) will come under increasing strain in most countries with shifts to a greater proportion of the population being retired and living longer. Many people will be living decades after leaving the workforce.
Forseeable change includes:
- The eligibility age for the pension and other assistance is gradually being increased and pressure will build to increase it faster.
- Eligibility requirements on assets and income will tighten further. At some stage, there will be pressure to at least partially include the value of the family home as the inequality between homeowners and non-owners will grow to be massive.
- The "taper rate" at which the full pension and other supplements are reduced based on asset or income levels will increase.
Currently, the key pension lesson is that, if you own the home you live in, then the government pension alone can easily cover the costs of retirement if you have a simple living philosophy.
There will be gradual changes to tighten income and asset limits and the rate at which the full pension reduces to zero, so see an up-to-date website like SuperGuide for the latest info. As of September 2017, the current guidance on income and asset test thresholds is:
"PART Age Pension: A single home-owner can hold up to $552,000 in assets, before losing their small PART Age Pension entitlement, while a home-owning couple can hold up to $830,000 in assets before they lose their small PART Age Pension entitlement.
FULL Age Pension: A single home-owner can hold $253,750 in assets before having the FULL Age Pension entitlement reduced, while a home-owning couple can hold $380,500 in assets before having the FULL Age Pension entitlement reduced."
> SuperGuide - Age Pension: Assets test thresholds applicable from September 2017
"PART Age Pension: From 20 September 2017, a single person can earn $1,956.80 a fortnight (or the equivalent of $50,877 a year), before losing a small PART Age Pension, while a couple can earn $2,996.80 a fortnight (or the equivalent of $77,917 a year) before they lose their small PART Age Pension. (From 1 July 2017 until 19 September 2017, a single person can earn $1,944.60 a fortnight, or the equivalent of $50,560 a year, before losing a small PART Age Pension, while a couple can earn $2,978.40 a fortnight, or the equivalent of $77,438 a year, before they lose their small PART Age Pension.)
FULL Age Pension: Since 1 July 2017, a single person can earn $168 a fortnight (or the equivalent of $4,368 a year), before having the FULL Age Pension entitlement reduced, while a couple can earn $300 a fortnight (or the equivalent of $7,800 a year) before having the FULL Age Pension entitlement reduced. The income thresholds for the FULL Age Pension will be increased again from July 2018."
> SuperGuide - Age Pension: Income test thresholds applicable from September 2017
Note that once over the income or asset limit for the full pension, the amount reduces quickly in proportion to other income received.
The biggest issue to consider in the latest changes is the taper rate increase from a pension reduction of $1.50 per $1,000 of assets over the threshold to $3 reduction. Unless your assets have very high return rates this will force many to over-invest in their home, bring forward future purchases, gift money to relatives, and spend a lot more early on (e.g. on overseas holidays) rather than spread out this spending.
See:
> SuperGuide - Age Pension: 330,000 Australians lose entitlements from January 2017
> SuperGuide - Age Pension January 2017 changes: Latest comments from readers
Anyway, here are some comparisons:
- My current simple living expenses excluding rent and holidays are about $11,000/year.
- A single homeowner pensioner receives $22,805/year tax free just from the pension.
- A single homeowner pensioner with $542,501 in non-home investments might receive a 4% tax-free investment return of $21,700 but has just crossed the borderline of where the pension reduces to zero. They are receiving less than the $22,805/year pension in income and with no part pension. So those with significant non-home investments will need to factor their investment return rate against the loss of any pension entitlement.
Further Info:
Forbes
> The 4% Rule And The Search For A Safe Withdrawal Rate
Mr Money Mustache
> The Shockingly Simple Math Behind Early Retirement
> The 4% Rule: The Easy Answer to “How Much Do I Need for Retirement?”
Financial Mentor
> Posts tagged "retirement planning"
Morningstar
> Safe withdrawal rates for Australian retirees
Retirement Researcher
> Retiring in a Low-Return Environment
Money Crashers
> Nominal vs. Real Interest Rate – Effects of Inflation
Australian Government
> Payment rates for Age Pension
ASIC MoneySmart
> How much is enough?
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