I spend a lot of time helping people understand how much money they will need to meet their retirement goals. Today I want to look at this another way: What will $1 million actually get you in retirement? This is an interesting question because a) many people believe that $1 million is a comfortable amount to meet their retirement goals and b) we can look at the different ways in which a couple can use this $1 million without running out of money.
Like any retirement calculation, this one involves many assumptions. But as long as our assumptions are reasonable, say 6% for equity returns rather than the 10% figure that many people used to use, we can come up with a very reasonable estimate for how much money one needs to retire comfortably.
Let’s start with the assumptions I used for the couple we will look at:
Before generating a retirement plan for this couple, the first thing we need to clear up is: What constitutes success? We live in a dynamic world, especially when it comes to investing. So I like to look at the probability of never running out of money in retirement using Monte Carlo analysis, where thousands of scenarios are run, with shocking investment returns in every scenario in every year. In this example, I will define success as having a probability of at least 80% that funds never run out in retirement.
Using Monte Carlo analysis in our retirement planner
I calculated that the probability they never run out of money is 95%. This easily meets our definition of success. In fact, this couple can spend more than $50,000 and still succeed, given that our definition of success is that the probability that funds are never depleted is 80% or more.
So how much can this couple spend and still have an 80% chance of achieving all of their retirement goals? I ran some scenarios and found the answer to be $55,000. This is the amount they can spend each year and still have an 80% chance of never running out of money. Yet another question we can ask is: How can they spend $55,000 in retirement and raise the probability of never running out of money? There are really only two ways to do this since this couple is already retired (assuming they don’t want to go back to work): They can find higher returning investments with the same level of volatility they currently have, or they can find investments that have the same returns, but less volatility.
My favorite way to reduce volatility while maintaining reasonable levels of return is to buy high quality dividend paying stocks that have a history of rising dividends over time. A few of my favorite dividend payers for retirement portfolios that have consistently raised their dividends over the years are Johnson & Johnson
(NYSE:KO), and Eli Lilly
I replaced their Equity Value fund with the stocks listed above, equally weighted. I kept the same total return assumption, but lowered the level of volatility to the historical levels of these stocks. That is, I reduced the volatility level from about 16% to 13% per year.
The probability that this couple never runs out of money now jumps from 80% to 88%. This is a large jump, solely due to the fact that they are now invested in more stable, solid dividend paying stocks instead of an equity index fund.
Each person and every couple has a different situation and might need to change a variety of things in order to meet their retirement goals. But it is usually impossible to tell whether or not you can retire when you want until you sit down and actually run through the numbers. At that point, you can begin running interesting scenarios that will tell you what you need to do to get to your goals.
Editor's Note: Douglas Carey is a regular contributor to Minyanville's blog.
No positions in stocks mentioned.