How Much Will You Need To Retire?

Charlie Munger famously said tell me where Im going to die, so I know to never go there. While this is clearly impossible, so too is knowing when youre going to pass over to the other side. If it were known, retirement planning would in theory be far simpler, since you could calculate exactly how much money would be needed in order to spend a specific amount each day so that on your final day, you spent your last penny.

Of course, its possible to estimate life expectancy based on lifestyle, health and various other factors. However, this is only one part of the equation. The other part is made up of just as many other variables thatare impossible to accurately predict. Things such as investment returns, inflation and the health of companies from which you receive dividends are all known unknowns. Therefore, retirement isnt particularly easy from a financial perspective, with there being a real risk that your cash runs out before you kick the bucket.

Play by the rules

As such, it seems sensible to adopt a few simple rules when deciding how much youll need to retire, such as investing in shares thatpay decent dividends. This is fairly obvious, but even though retirees can have long-term time horizons lasting multiple decades, it still makes sense to buy shares thatwill allow you to maintain your level of shareholding and spend the income you receive.

As a result, buying shares thatpay a 4% yield could be seen as a prudent move. In fact, withdrawing 4% of a portfolios value each year has long been held as a retirement rule of sorts, with it allowing the retiree to generate an income from their portfolio without sacrificing their capital. And if the companies in which youre invested pay 4% year in, year out, then your capital can fluctuate as much as it likes and it will still be able to generate an income for you in the long run.

Theres a catch

The problem, though, is when that 4% yield falls. In other words, the companies thathave paid 4% or more in dividends in prior years decide to cut their dividend payments due to either external or internal challenges. Clearly, its possible to research the companys ability to pay dividends. But as we saw in the credit crunch, even companies thathad excellent track records of making shareholder payouts experienced deep financial problems.

In this scenario, withdrawing 4% may be more painful since it can lead to the erosion of capital. However, by diversifying among different companies, sectors, geographies and for more risk-averse investors, different asset classes, its possible to generate a more stable and less risky income stream. This should enable you to generate a decent income in the long run without impacting negatively on the capital value of your portfolio.

As for the figure thats required in order for you to hand in your notice at work for good, unless you know when youll die and what real investment returns youll achieve, then the figure is at best an estimate and at worst a guess. Far simpler is to take out only what you need each year and invest in a wide range of assets thatseem likely to generate a high, growing and stable income for the long run.