**by Todd R. Tresidder**

Make everything as simple as possible, but not simpler. Albert Einstein

According to the New York Times, 75% of Americans have less than $30,000 in their retirement accounts, and 49% of middle-class workers will retire poor or near poor.

According to Hewitt Associates, 4 out of 5 workers will fail to meet all their financial needs in retirement.

Employee Benefit Research Institute reports that 81% of workers nearing retirement age (45 or older) have less than $250,000 in savings and an astounding 48% have accumulated less than $25,000 as they approach retirement.

Retirement planning done right is built on three separate models.

1. The first model is conventional retirement planning. Its dangerously misleading because it appears scientific, but its actually a fiction based on flawed premises. It works acceptably well for retirements up to 20–25 years in duration because its built on spending the principal in your savings account, but it runs into serious problems when your retirement time horizon exceeds 30 years. The first half of this book explains the problems with the traditional model with workaround solutions so you fully understand how to apply this model wisely.

2. The second model focuses on the increasingly important role creative lifestyle planning plays in modern retirement planning. The New Retirement is redefining the word “retirement” and completely changing the math behind how much money you need as a result. This section provides powerful planning tools that can help you close the savings gap or retire with greater financial security several years earlier than expected.

3. The final model in this book presents an entirely different approach to understanding how much money you need to retire based entirely on cash flow instead of assets. It’s valid for retirement time horizons exceeding 30 years, eliminates any need for difficult assumptions, simplifies, and is more robust (but also more difficult to attain).

When you calculate your number and pick that starting point, it’s usually a wakeup call. It gives you a concrete goal to work toward when previously there was none. It’s impossible to do it perfectly, so don’t worry and just do what it takes to get started.

Without a retirement number, your savings and investment plans are aimless. You know growing wealth for retirement is important, but how much and by when? It’s too vague. By calculating a savings number and an expected date for retirement, all vagary ends and the serious planning can begin. In short, it’s an essential step to reaching your goal of retiring with financial security and confidence.

Hidden behind the scientific façade of computers and mathematics are some very big assumptions. None of these questions can be answered with certainty, yet all of them must have accurate answers or your estimate for how much money you need to retire will be wrong.

Nobody even knows what will happen next year, not to mention 30 years from now, because the future is unknowable. Change just one of these inputs significantly and the amount you need to save for retirement will change dramatically—sometimes by as much as 2–3 times your original estimate.

The reality of retirement planning isn’t the science you’d like it to be. Financial advisers provide their clients with simple-to-understand retirement projections filled with pages of detailed pro-forma forecasts. Unfortunately, these plans are precise but not accurate. They can’t be. It’s impossible.

Unfortunately, the scientific façade of the process deceives people into believing the output is accurate when it’s nothing more than a mathematical projection of impossible-to-make assumptions.

People bet their future on this fictitious output every day because they don’t understand one basic truth: the only way their magic retirement number will be accurate is if the future matches the assumptions built into the calculation (highly unlikely). If the future differs from the assumptions (almost certain to occur), then the output will be wrong. It’s as simple as that.

The key is not which calculator you choose, but which assumptions you choose for the calculator.

Assuming stocks will return 8% every year is seriously misleading when actual returns can (and will) vary widely from that average estimate.

Question 1: How Much Income Do I Need For Retirement?

it’s equally true that your expenses may rise during retirement rather than fall.

Fun costs money,

For example, the average nursing home stay can cost more than $74,000 per year and could rise to over $150,000 per year by 2030 assuming annual inflation costs of 3%.

In short, it’s entirely possible

If all this contradictory research leaves you uncertain, then you’re not alone. The truth is that each individual’s situation is unique and no generic assumption will be accurate—least of all a simple rule of thumb like spending 80% of pre-retirement income.

The best solution is to formulate your own budget based on your life plans and make your best guesstimate. Below is a 5-step process to complete the task:

1. Start calculating your retirement spending estimate by using one full year of your current spending as the benchmark. Include all items paid annually (insurance, etc.), all holiday expenses, and everything you can think of so that it’s comprehensive. Make sure you get as complete a picture as possible.

2. Adjust those spending expectations for any unique plans you have for retirement. Will you be enjoying a lot of travel and recreation during your early retirement? If so, then add those expenses into your early budget and pull them back out after your wanderlust is satisfied. Will you pay off your mortgage? Will your health insurance costs change? Did you eliminate dry cleaning, suits, and commuting costs? What about retirement savings contributions?

3. Bernicke is correct in showing it makes sense to vary spending based on your plans and age bracket. As you get older, you can expect to spend less in nominal dollars so go ahead and build that into your retirement plan in nominal dollars.

4. Next, adjust your expected spending for inflation. (How to do this will be explained in the next chapter.)

5. Finally, add an assumption for long-term care costs depending on whether or not you are purchasing insurance. If you’re insured, you need to include the premiums, and if you aren’t insured, then maybe you should add a cushion for later years to self-insure that risk.

In summary, you’ll want to vary your expenses appropriately over your entire lifecycle to reflect your true expected spending during retirement—but then you must turn around and adjust those expenses by increasing the nominal dollars shown to adjust for expected inflation.

Finally, always remember that no matter how thoroughly you budget and plan, you’ll likely be wrong.

The best solution is to build your own budget based on your unique plan for retirement. It won’t be perfect, but there’s no better alternative for answering this required assumption.

Make your retirement plan a dynamic process.

Question 2: How Does Inflation Impact The Amount Of Money I Need For Retirement?

I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around (the banks) will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs. Thomas Jefferson

In short, assuming 3% inflation is little more than a guess based on a fairly narrow interpretation of history.

What can you expect going forward? I don’t know. To answer that question accurately would require a crystal ball or a direct connection to a higher power. I don’t have either and neither does your financial planner.

Simply stated, inflation is the single biggest threat to your retirement because it can’t be accurately estimated, you have no control over its occurrence, and the effect is compounded over time, thus magnifying small errors into big problems. Depending on other assumptions, increasing inflation by a mere 2% can easily double your retirement savings needs. It is a big deal.

My suggestion is to stress test your savings requirements using a variety of expected inflation rates.

While nobody has a crystal ball, it would likely be prudent and realistic to give the U.S. currency a higher inflation assumption than 3%.

Question 3: How Does Life Expectancy Impact The Amount Of Money I Need To Retire?

Traditional financial planning attempts to answer this question by consulting life expectancy tables. For example, according to Social Security Administration data, a 65-year-old man can expect to live, on average, until age 83 and a 65-year-old woman to age 85.

Using actuarial tables for life expectancy is perfectly valid for an insurance company or the IRS where they are dealing with large pools of people and statistical relevance, but it’s not valid for you or me individually. You have one life and one retirement only. Nobody is 50% dead at age 73.

Planning your retirement based on an actuarial table runs the risk of leaving you with more life than money, and you definitely don’t want that.

Longevity is a rapidly developing science that is being fueled by the wealth of an aging baby boomer population that isn’t exactly embracing death with open arms. What has been true in the past about life expectancy is likely to go through dramatic changes in the next 30 years.

The longevity issue is important because planning a retirement nest egg designed to survive 20 years (age 85) is radically different from a nest egg that must last 40 years (age 105) or 60 years (age 125).

Another planning strategy is to purchase an annuity that insures unexpectedly long lives. It only pays after you become elderly (age 85, for example) and is relatively cheap to buy because of the low probability for payout.

Question 4: How Much Will My Company Pension and Social Security Pay During Retirement?

considers Social Security a nice bonus if it occurs, but that’s all. Your situation may be different.

Question 5: How Much Investment Income Can I Expect During Retirement?

When a man retires, his wife gets twice the husband but only half the income. Chi Chi Rodriguez

Alternatively, if your retirement portfolio is non-traditional then your expected return may look completely different.

Maybe you built a portfolio of dividend paying stocks where the income has risen every year and exceeds your expenses. Or maybe you built a business that is paying you annually on a long-term installment sale. All of these are non-traditional asset allocations that many people use to successfully fund their retirement.

Another possibility is to build your retirement portfolio with traditional assets, but approach asset allocation in a non-traditional way.

Question 6: How Does the Order of Returns and Market Valuation Affect Your Investment Return Assumption

Question 1: Can I predict my investment return in any useful way?

However, over a decade or more, the research is clear that investment return is not random. Instead, return can be related to the market valuation2 at the beginning of your investment holding period.

The amount of return you can expect from a diversified equity portfolio is inversely correlated to the market valuation at the start of the holding period.

If your retirement begins with high valuations, you should expect lower than average investment returns and if your retirement begins with low market valuations, you should expect higher than average investment returns.

cyclically-adjusted price earnings ratio (CAPE4) for the 10 best years averaged 10.92 (well below average) with an average 10-year subsequent return of 16.1% compounded annually. The CAPE for the 10 worst years averaged 23.31

The bottom line is valuation matters. High valuation periods at the beginning of your investment holding period lead to low subsequent 10-year returns and low valuation periods lead to high subsequent returns.

Question 2: Why can’t I spend 7.4% from my savings annually if the average inflation-adjusted return from my investment portfolio is 7.4%?

The only return you can spend to support your living expenses in retirement is the compound return5, and compound returns are impacted by short-term volatility.

two key ideas to take away from this discussion on volatility

Compound return is always less than average return, and compound return is the only return you can spend. It’s what determines your portfolio value, not average returns.

Secondly, the difference between average and compound return is a function of how volatile the asset is. The more volatile the returns stream, the bigger the gap between average investment return and compound investment return.

third leg of the triangle

Question 3: Do good and bad investment years average out over the long run or does it matter what order those returns occur in?

Same annual returns, same average return, same compound return, different sequence of returns—vastly different result.

Imagine 15 years of no net investment gain (not hard to do with the stock market’s performance following year 2000) while still withdrawing 4% per year for spending (an amount deemed safe by traditional financial planning but warned about in The 4% Rule and Safe Withdrawal Rates ebook). Even without inflation adjustments, you would wipe out 60% of your account just in spending alone. When you add inflation and investment losses to the equation, the overall destruction to equity would be the retirement equivalent of death by strangulation.

sequencing of returns risk defines the third side of our investment return triangle.

The greater the volatility and/or the worse the sequence of returns, the more dramatic the negative impact will be on your ability to spend money to support your lifestyle in retirement.

Spending from your portfolio adds insult to injury during periods of market adversity. It’s why the order of returns is so terribly important and why volatility matters. A series of losses early on combined with spending can devastate a retiree’s financial future.

Sequence of returns is determined by the date you retire, cannot be known in advance, and will be one of the most significant factors affecting your financial security in retirement.

1. Sequence of returns can dramatically impact how much you can safely spend from your savings. 2. Compound return is the only return you can spend and is less than average return due to volatility. 3. Valuation informed investment return estimates provide useful information not available from any other approach.

any calculator that randomizes the return data is misrepresenting reality.

Ed Easterling (CrestmontResearch.com) brilliantly revealed this fact when he tested the industry standard 4% Rule against all 30-year periods in stock market history (index including dividends) beginning in 1900. He ranked each 30-year period by market valuation as determined by the price/earnings ratio on the first year of retirement then organized those data periods into 4 separate quartiles2 of market valuation from highest to lowest. Below are the results:

Market valuation at the beginning of your retirement is a powerful indicator of your risk of financial failure during retirement.

The Monte Carlo and backcasting approaches completely miss these important facts regarding the importance of market valuation in assessing retirement failure risk. They assume investment return is random and has no relationship to any factor that can be known when you begin retirement. This assumption is not supported by the data.

Monte Carlo does not reflect human nature. It assumes spending patterns will remain fixed according to an algorithm when in fact real retirees increase spending when their assets grow and decrease spending when their assets decline in value.

Estimating Your Investment Return Using Valuations

That’s why valuation metrics at the beginning of your retirement are a superior modeling tool. It’s the only investment return modeling approach that gives you useful information for your actual retirement time horizon.

The amount you can withdraw from your savings over your entire retirement is related to your first 15 years of investment returns after you retire.

The research is clear—valuation matters. It’s a valid indicator for narrowing the range of investment return results you should consider when estimating how much money you need to retire.

The first step in determining a reasonable expectation for your investment return assumption is to examine market valuations on the day of your analysis and compare them to the tables provided earlier in this book. This

Complete your calculations using a retirement calculator that allows you to control the investment return assumption. (No backcasting or Monte Carlo calculators; see my Ultimate Retirement Calculator.) Use historical averages as a starting point, then range up or down from there based on the valuation analysis above to create a confidence interval.

Don’t assume investment returns below fixed income (bonds) because you could always lock in fixed income returns, fixed annuities, and/or purchase TIPs2 as a no-brainer alternative.

Only assume returns above long-term historical averages if you have a non-traditional portfolio with the investment experience to support higher return expectations or the markets are below historical average

The truth is that your investment returns won’t be totally random nor will they be representative of all periods in history. Instead, it’s wiser to assume your returns will relate in some way to the most representative sample of history—the period that matched similar market valuations to what you face on the day you retire.

A Simplified Model To Calculate Your Magic Retirement Number

You want to know what the critical assumptions are that dramatically affect your estimate.

How To Build A Confidence Interval

To build a confidence interval, just vary your assumptions by raising inflation, lowering your pension payments, and decreasing your investment returns.

That’s exactly why I’ve claimed all along that there’s no such thing as The Number. It all depends on your assumptions. Garbage in equals garbage out.

You should have 20 or more test cases using various assumptions before you’re done. • Try adjusting your income needs to include taxes. • Try adjusting your net investment return based on current market valuations. • Make sure one extreme of your interval includes all your best case assumptions and the other extreme includes all your worst case assumptions including adjusting for taxes.

The reality is that even though there are many different ways to calculate your retirement number—from the simplest as shown on these pages to the ultra-complex Monte Carlo—they all produce remarkably similar conclusions.

Again, the conclusion is that it’s not so important what mathematical model you apply, but what assumptions you use. The assumptions will make or break your retirement, not the model. Don’t be deceived by the apparent rocket science of some expert’s fancy computer model.

The amount you can sustainably spend from a portfolio is determined by what it earns after adjusting for inflation, volatility, and sequence of returns. That’s it—end of discussion.

The first simple model is known as the Rule of 25. According to this rule, you figure out how much you’ll spend in your first year of retirement and multiply it by 25 to get the total savings required.

If you’re worried about sequence of returns or choose to retire during a period of high market valuation, there’s still no need to get fancy. Instead, you can just make this simple model more conservative by changing it to The 3% Rule or the Rule of 33, thus limiting your first year spending in retirement to 3% of assets. The end result will be remarkably close to more elaborate models.

Critical Number 1: Percentage of income saved versus income spent.

10% savings rate = 42 years • 20% savings rate = 32 years • 40% savings rate = 21 years • 50% savings rate = 17 years • 60% savings rate = 14 years • 70% savings rate = 10 years

Critically Important Number 2: Return on investment minus inflation.

Both inflation and return on investment have a compounded effect on your estimate for how much money you need to retire.

Principle: Small changes in a few key numbers multiplied over long periods of time have huge impacts on your ability to retire with financial security. Therefore, focus on those key variables and don’t worry about the minute details.

Walk Forward Process: Don’t perform the retirement savings goal exercise once, put it on a shelf, and then forget it.

check back every few years and see what assumptions proved valid and which ones did not.

Errors Multiply: Small errors in estimates compound into large errors in results.

Teach Principles: Retirement calculators are invaluable for teaching essential retirement planning principles.

Maintain Flexibility: Avoid calculators that limit your ability to change assumptions.

Creative Lifestyle Planning

In high valuation/low interest rate investment periods, you should consider keeping expenses under 3% of invested savings and in low valuation/high interest rate markets, you can consider being more aggressive toward 5%.

Reduce your expenses. • Increase your savings. • Or increase the spread between investment return and expenses.

you want to focus your retirement planning energy on what really matters: your assumptions.

Rule of 25 tells you that for every $12,000 you can shave off your annual retirement budget ($1,000 per month), you’ll reduce your savings required by roughly $300,000. That’s a big deal.

Income-producing real estate can provide an income stream you never outlive with the added advantage that it grows over time to offset inflation.

Dividend-paying stocks can provide an income stream you can never outlive that historically has grown faster than inflation to preserve purchasing power.

Inflation Risks: If you’re concerned about inflation, then consider investment strategies specifically designed to manage that risk. For example, on the fixed income side you may want to choose TIPS over regular bonds, while on the equity side you may want to look at dividend growth stocks2 over traditional equity allocations3 to capture the fact that both dividend payments and stock growth rates have historically outpaced inflation.

An insurance contract providing a fixed payment stream for life in exchange for a single lump sum purchase. An optional feature is to increase the payments over time based on the rate of inflation to protect purchasing power for the investor.

An immediate annuity that defers payments until a future date. For example, an annuitant could purchase longevity insurance at age 65 that pays $5,000 per month beginning at age 85.

My Simple Three Rule System That Allowed Me To Retire At Age 35

As it turns out, the process is far simpler than you have been led to believe.

The first rule is that you must build an investment portfolio that throws off residual income in excess of personal expenses. Please note that the income referred to here doesn’t have anything to do with total investment return, but only refers to residual income.

You can only spend the income thrown off by the assets, but the assets themselves can never be touched.

At this point, your life expectancy is irrelevant because you can never outlive your income.

The second rule is that you must manage your assets so that growth (total return-income) is greater than the inflation rate.

As long as the difference between your total return and the income from your assets exceeds the rate of inflation, then you can remove any need to estimate future inflation from your calculations. It becomes a non-issue.

The third and final simplifying rule is that your passive income must come from multiple, non-correlated sources.

A reasonable mixture of TIPS, dividend paying stocks, income producing real estate, inflation-adjusting fixed annuities, and alternative investment strategies would satisfy that requirement.

What you don’t want to do is retire based on one source of income.

diversify your assets so if any one source of income gets wiped out you can still survive comfortably and buy yourself enough time to eventually recover.

Never leave yourself exposed to a single default that can wipe out your financial security.

To be very conservative, don’t retire until your cash flow exceeds what you spend so you have money left over to reinvest for future growth.

Reinvesting excess revenue allows you to compound your way back over time from any adverse circumstance.

The real goal is sustainable spending, not portfolio value. That’s why this simple cash flow model works so well. Assets are just the middleman that throws off the income and is at best loosely correlated to what really matters: spendable money to pay the bills.

You just spend your working career acquiring income-producing assets that grow with inflation until your passive income exceeds your expenses.