Retiring With $2 Million Portfolio

Reader Question

I am planning to retire later this year. I would appreciate your thoughts on how I should set up my retirement portfolio. Here's my situation:

1. 61 years old / married / own home with no mortgage / no debt / would like about $100K - $120K / year income retirement 
2. Will receive a pension of $55K per year with no cost of living adjustment 
3. Have $1 million in a 401K that is invested 1/3 each in TIPS, US stock index fund, foreign stock index fund 
4. Have $1 million in online savings accounts that was recently received from an inheritance and sale of some real estate 
5. Plan to wait until age 70 to start Social Security 
6. Both my wife and I are in good health and expect to live into our 90s based on parents and other relatives life expectancy 
7. Am comfortable managing my own portfolio and am willing to accept the risk of some market fluctuations Thanks. 

My Reply

Thanks for writing. Unfortunately you didn't mention the amount of your eventual Social Security, but we can make some guesstimates. Overall I think you are in excellent shape, assuming your Social Security payment will on the order of $40,000 or more annually (in today's dollars) which seems like a very safe assumption. There would be a decent chance of things working out the way you want even if you did not have any Social Security at all.

Here is how I view your financial requirements and realities, step by logical step:

1. Good idea postponing Social Security till age of 70, especially in light of your high life expectancy.
2. Due to your young age, being married, and good health and high life expectancy I would be looking at a 40-year investing horizon for you and your wife. Maybe a little optimistic, but in these matters optimism is preferable.
3. Because of the long 40-year outlook you probably should plan for a more conservative withdrawal strategy than the 4% of initial portfolio (adjusted up for inflation) that's generally advised. The 4% is based on the 30-year outlook and has never failed historically (with the caveat that all such historical data is imprecise), though there is a good chance dot-com bubble era retirees may find it failing them.
4. My rule of thumb is to knock off another 0.5% from the withdrawal rate for each decade past 30 years. I happily admit that I did not arrive at this rule of thumb by churning through millions of Monte Carlo simulations. I did it by guesstimating which I find to be just as accurate or inaccurate -- and a lot less time consuming -- when it comes to unknowable future. That puts you at 3.5% withdrawals. Let's go ahead and knock off another 0.5% for even more safety and start you off at 3.0% withdrawals from your portfolio that will grow with inflation. Being conservative in these guesstimates is a good idea anyway, but especially appropriate now when bonds are clearly much more expensive than historical average and stocks are not bargain-priced either. It is likely that future returns (next couple of decades) will be less generous than historical averages.
5. Switching gears to your requirement of $100,000-$120,000 annually in income... Let's go with $100,000, but adjust it for the inevitable income taxes. Future taxes are unknowable, of course (and I don't know your state income taxes) but let's say we'll need $120,000 in annual withdrawals of which $20,000 will go to taxes, leaving you $100,000 to spend. This would be assuming more or less zero cost basis in your investments, such as would be the case if everything was in an IRA or 401k. In reality you have $1,000,000 in taxable in cash and chances are you have some taxable or Roth IRA investments as well which would bring down the impact of taxes. So our tax estimate is very likely on the high side. Again, better safe than sorry.
6. You have a $2 million portfolio. Our starting 3.0% withdrawal rate gives $60,000 of annual inflation-adjusted withdrawals every year. That means we only need another $60,000 from pension and your eventual Social Security to get to the $120,000 annual requirement.
7. Unlike every other dollar number we use here, your pension dollar amount will not be inflation-adjusted. So let's translate your pension payouts from nominal dollars to "virtually inflation-adjusted" ones, so we can treat it like all the other amounts we mention here... Let's assume constant 3% annual inflation over 40 year (again, being conservative -- market estimates inflation of under 2% for the next couple of decades). Then we find that in real inflation-adjusted terms your pension shrinks from $55,000 today to about $40,000 by the time you start collecting Social Security to about $15,000 by the end of our 40-year period.

Let's stop here and review... Under our conservative assumptions you need $120,000 in annual inflation-adjusted withdrawals to have $100,000 (again, inflation adjusted) in income after taxes. To have a very high chance of your portfolio's lasting 40 years we pegged withdrawals at 3% of starting portfolio value, or $60,000 which will grow with inflation. In the first year your pension will deliver another $55,000 year, leaving just $5,000 shortfall which is basically a rounding error given the guesstimated nature of this whole exercise. You will simply withdraw that extra $5,000 from your portfolio, moving the needle from 3.0% withdrawal to 3.25%. Since your pension will continue to shrink in real terms, you will have to increase your portfolio withdrawals all the way to $80,000 in that last pre-Social Security year. But that's still only 4% of your starting portfolio size (instead of the hoped for 3%) and is very unlikely to upset the overall plan because immediately after that last "large" withdrawal you will start getting your Social Security payments which need to be only $20,000 a year to put you back on track for 3% withdrawals. In reality they will be much, much higher, of course. I can't put exact numbers on it since you didn't mention what they will be, but let's say you will collect just $40,000 (again, all in inflation-adjusted terms) in Social Security starting at age 70. You will also continue to withdraw inflation-adjusted $60,000 from your portfolio. that leaves only $20,000 left to be covered by your pension which will meet or exceed that inflation-adjusted requirement till your are 90 or so (and by then chances are many things will have changed anyway, both for better and for worse).

To summarize, even with quite conservative assumptions all around, you should have no problems meeting $100,000 in income requirement after taxes for 40 years, growing with inflation. I like your 1/3 US stocks, 1/3 Int'l stocks, 1/3 TIPS portfolio (TIPS are relatively over-priced but not so much as to jeopardize your retirement). The only thing left to do is to allocate the $1,000,000 in online savings. There is a good chance things will work out even if you do keep it all in online savings, but I would try to allocate it more aggressively. After all, we are assuming a 40-year investing horizon. I am partial to a 50/50 stock/bond allocation, so you could, for example put a third of that million into stocks (same ones you hold already) and two thirds into bonds and/or CDs. I talked about it investing in bonds and CDs in a couple of recent blog posts: http://www.longtermreturns.com/2012/12/optimizing-fixed-income-portfolio.html and http://www.longtermreturns.com/2013/01/optimizing-investment-portfolio-with-municipal-bonds.html . Combined with your already-invested $1,000,000 that will give you a 50/50 stock/bond allocation. 

But there is no rush to do any of this. You should take your time thinking through exactly what kind of asset allocation you wish for the next 40 years. Historically speaking, a very wide range of balanced portfolios has had about equal chance of lasting a long time. The 50/50 is just my personal favorite for its simplicity. Overall you are in great shape and the exact stock/bond allocation is a minor detail rather than a major decision point for you.