shanebagel wrote: ↑
Thu May 16, 2019 9:06 am
Current age: 21
Current annual salary: 50,000, currently 16,000, but I am graduating from college in a year so I expect to make more money
Current Portfolio size: 30,000
2060 target retirement date fund, 90% stocks 10% bonds
Social security pensions unsure
shanebagel wrote: ↑
Thu May 16, 2019 9:18 am
I don't know if this helps, but I also plan to contribute %50 of my income to investing. I want to put half into mutual funds, and half into real estate.
Thanks for the information, Shanebagel. I think that we have enough to calculate a variable savings rate
(VSR) for the first year of work.
For simplicity, all calculations will be expressed using 2019 dollars*. All investing will be done in tax-deferred accounts (IRA, 401K, etc.). I'll also assume that the first full-year of work will be at age 22 at a $50,000 annual salary.
* In other words, all amounts will be adjusted to inflation, so that $1 in 2062 will have the same buying power as $1 in 2019.
My objective will be to calculate a (variable) savings rate for retirement savings
. Other savings, like accumulating a house down payment for example, will need to be done separately.
We need an estimate of the Social Security pension. Luckily, forum member Neurosphere has developed an easy-to-use Social Security Estimator
spreadsheet. Assuming that the salary remains $50,000 (inflation-adjusted) until retirement and Social Security is delayed until age 70, I got estimates for two scenarios:
- Early retirement at age 55: $2,129/month = $25,548/year
- Retirement at age 65: $2,129/month = $25,548/year
Let's start with the early retirement scenario. We're starting with a $30,000 portfolio which is invested into a Target Retirement fund. Target Retirement funds start with a 90/10 stocks/bonds allocation and eventually glide down to a 30/70 stocks/bonds allocation late in life. The average allocation to stocks is: ((90% + 30%) / 2) =
60%. So, I'll make calculations as if the portfolio had a constant 60/40 stocks/bonds allocation.
Nobody knows how much stocks and bonds will return over the next 80 years. So, instead of trying to guess future returns, I'll use what I call a growth trend
for both stocks and bonds. A growth trend isn't
a future return prediction; it's just a wild-ass guess
such that good returns are higher than this trend, and bad returns are lower than this trend. I'll use the historical long-term average returns of world stocks and bonds from 1900 to 2018 (a period of 119 years) which were 5.0% real
** for stocks and 1.9% real
for bonds according to the Summary Edition of the Credit Suisse Global Investment Returns Yearbook 2019
). For our 60/40 stocks/bonds portfolio, I get a ((60% X 5.0%) + (40% X 1.9%)) =
3.76% growth trend.
** Real means inflation-adjusted.
If returns were constant and equal to the growth trend (they're not!), the initial $30,000 investment at age 22 would grow to ($30,000 X (1.0376^33)) =
$101,417 at age 55 (33 years later). Let's remember this number and continue with the next calculation.
We've estimated that, when delayed to age 70, the Social Security pension is $25,548 per year, more than half of the $50,000 annual salary. This pension is quite valuable as it is indexed to inflation, unaffected by market fluctuations, and it continues for life! But, there's a 15-year gap between retirement at age 55 and the start of Social Security payments. It would be nice if the $25,548 Social Security pension could be extended back to age 55. This is something that can be done quite easily. At age 55, we'll put ($25,548 X 15) =
$383,220 into a high-interest savings account with an interest rate equal or greater than inflation, and then withdraw $2,129/month (adjusted to inflation, of course) from the account***. The savings account will get depleted just before the start of Social Security payments.
*** Actually, we'll withdraw 1/180 in the first month, 1/179 in the second month, ..., and 1/1 of the savings account balance in the 180th month. Note that 15 years is 180 months.
Of course, we'll need a big-enough portfolio so that we can move $383,220 from the Target Retirement fund into a savings account. Let's remember this and continue.
If we saved $1,000 per year and invested it into the Target Retirement fund from age 22 until retirement, we would get $63,313 at age 55. To calculate this, I needed to use a financial calculator
- n=33, i=3.76, PV=0, PMT=-1000, BGN=false => FV= 63312.79351 where:
- n: number of periods
- i: interest rate
- PV: present value
- PMT: periodic payment
- BGN: true = payment at beginning of period, false = payment at end of period
- FV: future value
We now have enough information to fix the Social Security gap. We need $383,220 at age 55 to do this. The initial $30,000 portfolio is currently projected to grow to $101,417 at age 55. We'll need an additional ($383,220 - $101,417) =
$281,803. Each $1,000 of annual saving and investing gives us an additional $63,313. So, we need to save (($281,803 / $63,313) X $1,000) =
$4,451 per year to fill the gap.
Let's look at it this way. If we start with a $30,000 portfolio and add $4,451 per year until retirement at age 55, and then move the investment into a savings account to fill the Social Security pension gap until age 70, we end up with:
- During accumulation: ($50,000 - $4,451) = $45,449 per year to pay taxes and expenses.
- During retirement: $25,548 per year to pay taxes and expenses.
OK, there's obviously a problem. For one thing, at age 70 we end up with no savings, waiting for the next Social Security payment to arrive. For another, annual pre-tax income (after savings) drops 44% from $45,449 during accumulation to $25,548 in retirement. That's a ($45,449 - $25,548) = $19,901 income drop!
We need to save more so that annual pre-tax income (after savings) remains equal during accumulation and retirement. We've already got almost all the pieces to fix this. We're missing one last piece. We need a portfolio withdrawal method. We'll use our wiki's variable percentage withdrawal
The withdrawal percentage, at age 55 for a 60/40 stocks/bonds portfolio in the VPW Table
, is 4.5%. We know that $1,000 in annual savings grows to $63,313 at age 55. VPW tells us that a $63,313 portfolio allows for a ($63,313 X 4.5%) =
$2,849 annual (variable) withdrawal in retirement. Let's put this together. For each $3,849 in salary, if we saved $1,000, we would be left with $2,849 to pay taxes and expenses during accumulation, and we would be able to withdraw $2,849 from the portfolio to pay taxes and expenses in retirement.
OK. We now have the pieces to fix the $19,901 in income drop. We need to save $1,000 for each $3,849 so that income remains balanced between accumulation and retirement. In other words, we need to save an additional (($19,901 / $3,849) X $1,000) =
$5,170 per year. This will allow for a (($5,170 / $1000) X $2,849) =
$14,729 annual (variable) withdrawal in retirement.
Saving ($4,451 + $5,170)
= $9,621 per year, ($9,621 / 12)
= $802 per month
, or ($9,621 / 26)
= $370 per bi-weekly salary payment
would result into similar pre-tax income (after savings) during accumulation and retirement:
- During accumulation: ($50,000 - $9,621) = $40,379 per year to pay taxes and expenses.
- During retirement: ($25,548 stable + $14,729 variable) = $40,277 (somewhat variable) per year to pay taxes and expenses.
Note that the small difference between $40,379 and $40,277 is due to rounding errors.
Let's recap. Given an initial $30,000 portfolio, a $50,000 salary from age 22 until early retirement at age 55, our calculations project that a ($9,621 / $50,000) = 20% variable savings rate
(VSR) would allow for similar pre-tax income (after savings) during accumulation and retirement.
But, we're not done yet because we know that our calculations are inaccurate (stock and bond returns aren't constant nor predictable). We have to make sure our plan allows for enough flexibility to adapt to market fluctuations. We're not worried about higher returns; it'll be easy enough to adapt when returns will be higher than projected. We want to plan for the possibility of lower returns so that we're ready to cut expenses when they happen (but we actually won't cut expenses before they happen).
I'll explain how to do that in a future post. I'll also explain why it's important to calculate a new savings rate every year, based on the new (shorter) retirement horizon, the new (hopefully bigger) portfolio balance, and the new (hopefully bigger, too) salary. I'll finally apply our calculations to the scenario of a retirement at age 65.
For now, you can take away the conclusion that saving and investing 20% of your pre-tax income into tax-deferred retirement accounts, during your first year of work, is likely a good enough
starting point toward an early retirement at age 55, given your age, your initial portfolio balance, the use of a Target Retirement fund, and a $50,000 salary.
Were my calculations (and explanations) clear enough, so far?