In the last three posts I’ve explained how to estimate the risk of coming up short of a savings goal using the FIRECalc retirement calculator, and how to use that estimate to optimize a savings/investment plan for any financial goal you may have. Of course, you can also use FIRECalc to estimate your shortfall risk in retirement—that is, the risk that you will outlive your money. More specifically, you can use FIRECalc to estimate your maximum safe withdrawal rate—the rate at which you can withdraw money from your nest egg without any risk, based on past history, of running out of money in retirement. As a very simple example, suppose you have saved $1 million towards retirement, and would like to know how much money you can withdraw from this nest egg in the first year of retirement without risk of going broke over the course of a 30-year retirement. To answer this question, you would go to the “Start Here” box on the FIRECalc home page, enter 1,000,000 in the “Portfolio” box, 30 in the “Years” box, and then try various values of “Spending” until you found the highest value that yields zero risk of running out of money. If you try this, you will find that spending of $36,000 in the first year of retirement will give you a 99.1 percent success rate, or, in other words, a 0.9 percent risk of running out of money. If you then reduce the spending to $35,900, your success rate rises to 100 percent—a zero risk of going broke. Hence, according to FIRECalc, you can safely withdraw a maximum of $35,900 in your first year of retirement, or 3.59 percent of your $1 million nest egg. You can then increase this initial $35,900 withdrawal by the rate of inflation in each subsequent year. (Note that in this simple example we used FIRECalcs default asset allocation of 75 percent stocks and 25 percent bonds, but it is possible to test alternative allocations on the “Your Portfolio” page of FIRECalc.)
Alternatively, you can use FIRECalc to estimate your “retirement number”—the amount of money you need to save in order to support a specific level of spending in retirement. Suppose that you would like to be able to spend $40,000 in your first year of retirement, and then increase this amount for inflation in subsequent years. To estimate your retirement number you would enter 40,000 in the “Spending” box, 30 in the “Years” box (for a retirement lasting 30 years), and then try alternative values in the “Portfolio” box until you found the smallest value that would yield a shortfall risk of zero. The result you get should be $1,113,000. And it should come as no surprise that when you divide this number into your $40,000 spending goal, the resulting withdrawal rate is 3.59 percent—the same maximum safe withdrawal rate we calculated in the preceding paragraph for a 30-year retirement and a 75/25 stock/bond portfolio.
Using the same basic process described in the last two posts to optimize a savings plan, you can similarly optimize your retirement number and safe withdrawal rate. For example, you can test alternatives to FIRECalc’s default asset allocation, and you can also consider changing the length of your retirement (by postponing your planned retirement). FIRECalc also allows you to include the impact of Social Security and other sources of retirement income (such as income from a part-time job) in your retirement plan.