Lassoing the Retirement Moon: Setting Realistic Expectations

Here’s the scenario: George and Mary Bailey, both 55 and active, want to retire early, in 2019. They need to be realistic about what lifestyle they can afford after they stop working.

George and Mary live frugally. Late last year, they paid off the mortgage on their home, which is now worth $200,000, and have no credit card debt. Their two kids have graduated from college and have launched their careers. Freedom beckons.

Combined, the couple earns $51,000 a year, the median household income in the United States for 2013, of which they spend about half on fixed expenses. They set aside 5% of their income each year in their company retirement plans.

Their dream is to take an extended trip to Hawaii around their 60th birthdays, and then eventually buy a small bungalow in a retirement community somewhere in
the Southwest.

Crunching the numbers
To determine whether these are realistic goals, let’s look at the couple’s overall financial situation in more detail. The Baileys have saved diligently and managed their
money well, and have set aside $500,000 in their Roth retirement accounts.

If they sell their home in five years for $250,000 and their retirement savings earn, on average, 8% a year and grow to $750,000 in that time period, they will have a total of $1,000,000 to spend on their retirement. (Assume, for the time being, that they won’t take Social Security until 67.)

At this rate, George and Mary easily will retire at 60 as millionaires. Sound like a perfect plan? Unfortunately, the numbers tell a different story. If they use a conservative rule of thumb to withdraw no more than 4% of their savings in their first year of retirement, the newly retired couple will have $40,000 to spend that first year. Assuming the two-week Hawaiian junket will cost them $10,000 and that their fixed monthly expenses are $2,000, their projected first-year income will just barely cover living costs and the dream trip.

Remember that the Baileys are active and healthy, so they likely will need their million-dollar nest egg to last well into their 80s and 90s. In addition, the Baileys will need to live somewhere. Even if they are able to buy a modest retirement home for $200,000, that will reduce their total available retirement funds to $800,000 in year two of their retirement. Even if they keep to their withdrawal rate of 4% in year two, and assuming a 5% growth in their retirement accounts in the same year, George and Mary will have $33,600 to spend—less than they had to spend in year one. Meanwhile, fixed expenses—housing costs, taxes, food, utilities, health insurance—will chip away at their nest egg.

The Baileys clearly need to reframe their expectations about their retirement. Here are a couple of possibilities that could help them find that “wonderful life”:

• They can increase their current savings rate to 25% of their pre-tax income. Assuming the same average rate of return, this will boost their savings to $812,168 at age 60 and their first-year retirement income to $42,487.
•  They can delay their retirement date and house sale to age 65—giving them five additional years of contributions. If their contributions earn 8% annually, their nest egg will grow to $1,520,845 by the time they reach 65, and a first-year withdrawal of 4% will net them $60,834 in income—more than enough to cover their fixed expenses and trip to the islands (and maybe an even nicer home).

George and Mary have another option, of course: They can set their sights lower. But what’s the fun in that?

Disclosure: This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.