Note: This article is a supporting article to the two-part series, ‘Crunching the numbers: a $1 million retirement’ and ‘Crunching the numbers: a $2 million retirement’ (links for these articles are set out at the end of the article).
Before I receive dozens of emails, let me start with the following statement: If you live off the earnings only from your invested capital then your capital can indeed last ‘forever’. The dilemma facing all investors and retirees is balancing the desired lifestyle (and maintaining that lifestyle over 20 to 30 years) with protecting capital, and potentially leaving some wealth behind for your children or other dependants.
Some of the most important questions you need to ask when planning for your retirement are:
- What type of lifestyle do you want? (see SuperGuide’s articles on how much super do I need?
- How long do you want this lifestyle? (see SuperGuide’s article Life expectancy: Will you outlive your retirement savings?)
- How much money do you have?
- What investment return are you hoping to achieve on your savings in retirement? (see SuperGuide’s articles on Is my super fund performing?, and also note that in many of our wealth articles we assume a 7% a year long-term investment return, or a 5% a year long-term investment return, but you may have different expectations)
- Do you want to leave any money to your children? (see also SuperGuide’s articles on death benefits)
- Is there a gap between your expectations and what you hope to achieve financially for your retirement?
In August 2014, we updated and revamped two articles on the SuperGuide website outlining what $1 million can deliver you in retirement, and what $2 million can provide in retirement. The two articles have been very popular articles on the SuperGuide website, and consequently I received many emails challenging the fact that $1 million could run out when earning 7% after fees in a tax-free environment, and when receiving a certain level of income. We have updated these articles with an explanation of today’s dollars (the links for the two updated feature articles are at the end of this article).
In collating the figures for the two features, I relied upon the Australian Securities & Investments Commission’s MoneySmart retirement planner calculator. For an official response, I forwarded a selection of reader questions (just the questions not the actual emails) to the creators of the MoneySmart calculator. They provided explanations for why a $1 million retirement can still mean that you eat into your capital and eventually run out of savings.
Three popular questions from readers
Three questions from readers, and ASIC’s response to those questions, are set out below:
1. Reader question: Can you please explain to me how the million dollar super ever runs out? My thoughts are, if you have a million dollars in super and it returns 7% then you acquire $70,000 a year. This is just spending what your fund earns, not the one million dollars as a principal sum, so why does it ever run out?
ASIC’s response: The MoneySmart Retirement Planner works in “today’s dollars”. So if we assume an inflation rate of 3%, the calculator also increases your drawdowns by 3% each year in order to maintain a similar lifestyle. This means that a $70,000 withdrawal per year would partially dip into your capital after year 1. Or, expressed another way, a notional return of 7% is equal to a real return (after inflation) of 4%. If you only withdrew 4%, it would last forever.
Note: You can see the difference between today’s dollars and tomorrow’s dollars in the table appearing later in the article.
2. Reader question: I just don’t get it. If I have $2mil @ 7%, I generate $140,000 pa so how can my super run out at 87 or 100 if I only withdraw $100,000 pa? Will my super not keep growing? Or is it to do with the aged-based minimum withdrawal increases?
ASIC’s response: If we assume an inflation rate of 3% we also assume that you will increase your drawdowns by 3% each year in order to maintain a similar lifestyle. In effect, your real returns are only 4% each year. This means that you would start to dip into your capital after year 1. You earn 4% in real terms [Trish’s comment: but the amount being withdrawn is more than 4% in real terms each year, which explains why your capital base falls].
If you start at age 65 with $2 million, you can draw $106,000 income per year (indexed to inflation) and your funds are estimated to last until age 100.
3. Reader question: I wanted to ask about your statement in this paper [in the introduction of $1 million retirement article] to the effect that a “lump sum of $445,000* can deliver a couple nearly $56,000* (indexed) a year in retirement (which includes the couple’s Age Pension entitlements) until the age of 87?. Using an Age Pension calculator, I get a figure of approx $20,000 per annum from the Age Pension (for a couple). That leaves about $38,000 per annum to make up. Trouble is, according to my calculations anyway, with a super balance of only $445,000, I can’t see a way to generate $38,000 for 22 years, even if invested at 7%, especially if we insist on indexing it at 3%. Have I missed something?”
ASIC’s response: The full Age Pension for a couple is roughly $33,000 a year, while for a single person it is around $22,000 a year. On an account balance of $445,000*, the MoneySmart Retirement Planner estimates the income (age pension + super) to be around $58,000*, which includes a substantial part Age Pension, or full Age Pension for many of those retirement years.
Trish’s comment: For clear confirmation of the figures, I have assumed the $445,000 has to fund a super income stream of $29,000 a year (which means assume maximum Age Pension amount is $29,000 a year in today’s dollars, a healthy part Age Pension, although in most years the couple will receive a greater Age Pension entitlement). Using the account-based pension calculator to double-check figures, at 7% return after fees and 3% inflation, the allocated pension account can be expected to deliver an income of $29,000 for 22 years. Note that this calculation is simplistic because the mix of super and Age Pension entitlement varies each year.
Trish’s note*: These figures are adjusted by Trish Power to allow for Age Pension increases incorporated into MoneySmart Retirement Planner since the article was first published. The lump sum of $445,000, along with a substantial part Age Pension, delivers roughly $58,000 a year for a couple, assuming savings are invested in assets that return 7%, and annual income is indexed at 3%, and including Age Pension entitlements. SuperGuide’s calculations also assume no lump sum expenditure in the first year from the account balance.
Indexing your income protects your lifestyle
I also want to explain the how inflation (cost of living) and indexation (the modelling tool to combat inflation) translates into the concepts of ‘today’s dollars’ and ‘tomorrow’s dollars’.
The term, ‘today’s dollars’, is confusing especially when you’re looking up to 20 or 30 years into the future. Translating your tomorrow dollars into today’s dollars enables you to plan for the type of lifestyle that you want in retirement. If you use tomorrow dollars, they will be relatively meaningless when looking many years ahead.
Using an example, say you want to live on $50,000 a year in retirement and you plan to retire today. When you think of $50,000 a year I assume you’re imagining what $50,000 can buy you today and that’s the lifestyle you’re aspiring to. Cost of living increases are a fact of life nowadays so if you want to maintain the lifestyle that you can expect on $50,000 in today’s dollars, then you will need to increase your annual retirement income each year to maintain your lifestyle of today. If prices increase by 10% over the next three years, then in three years’ time you will need to be taking a retirement income of $55,000 a year, to match your lifestyle on $50,000 a year in today’s dollars. If prices increase by 20% over the next six years, then in six years’ time, then you will need to be taking a retirement income of $60,000 to match your current lifestyle on $50,000 a year.
The ASIC MoneySmart calculators automatically build the increase in payments into the calculations, although I use 3% cost of living adjustment in my examples, rather than the default 4.5%. For example, if I have quoted a lump sum amount that will deliver $58,000 a year for 22 years, then that lump sum takes into account increasing the annual income by 3% a year, even though we quote $58,000 in today’s dollars.
The $1 million and $2 million features referred to in this article (see links at the end of this article) allow for 3% inflation when working out annual incomes, so the figures in these features automatically allow for the annual adjustment in retirement incomes.
Comparing today’s dollars with tomorrow’s dollars
For those readers who are still sceptical about how $1 million, or even $2 million, can run out at certain levels of income, here’s another scenario.
For example, Beverley, age 65, retires today with $1 million. If she wants her money to last until she turns 100, and if she wants to maintain the lifestyle that she enjoys in her first year of retirement, then based on her savings, she can expect an income of $55,625 in the first year, and that income will be indexed each year by 3%, and she will run out of savings at the age of 100. In today’s dollars, Beverley’s annual retirement income for each year works out to be roughly $54,500 a year in today’s dollars (although significantly more in tomorrow’s dollars, that is, what she will actually receive each year).
Beverley’s friends think that she is being ripped off by these estimates. The friends work out that if you stick $1 million in the bank and in shares within her super fund, and the super fund receives bank interest and dividends and other income, at 7% a year (no fees or taxes), then Beverley’s money should never run out if she only takes out $55,625 a year. In fact, her savings should be growing not diminishing. Earning 7% on $1 million each year works out to be $70,000, and this figure should grow as she accumulates more retained earnings. What’s the story?
The ‘story’ is reasonably straightforward: If Beverley wants her lifestyle to be maintained, then taking out only $55,625 in 10 or 20 years’ time will not deliver her the lifestyle she wants. If Beverley withdraws $55,625 in absolute terms, that is, in tomorrow’s dollars, each year, then she will certainly retain her capital for longer, but her standard of living will dramatically decline in real terms, that is, in today’s dollars.
In 20 years’ time, Beverley’s lifestyle will have nearly halved in real terms, if she continues to take the same dollar amount that she first withdrew 20 years earlier.
I have used ASIC’s MoneySmart account-based pension calculator to calculate the income she needs to withdraw from your super pension each year in tomorrow’s dollars, to maintain today’s lifestyle of $55,625 (see table below), assuming 3% indexation/inflation. You can also do these calculations manually by multiplying $55,625 by 1.03%, and then multiplying that result ($57,924) by 1.03%, and continuing these calculations each year on the revised income in tomorrow’s dollars.
Note: In practical terms, if Beverley accepted that she was willing to have a lower standard of living as she got older, by taking out the same amount every year (without indexation) until age 87, then she could enjoy a higher standard of living in her earlier years (and higher income than $55,625 in tomorrow’s dollars) and cop the fall in lifestyle later.
|Beverley’s retirement income when retiring at age 65 with $1 million|
|Age (receiving retirement income)||Tomorrow’s dollars (actual payments||Today’s dollars (payments in real terms)|
|65 (retires today)||$55,625|
Source: Incomes in tomorrow’s dollars (using 3% indexation) verified used ASIC’s account-based pension calculator and referring to the ‘Pension 1’ tab in the calculator.
Crunching the numbers: Retiring on $1 (or 2) million
Due to popular demand, we have created a 2-part special on what a $1 million lump sum can deliver you in retirement, and what a $2 million lump sum can give you as a single person, or a couple, and whether you retire at 55, or at 61 or 65, 67, or even 70. Click on the article links below:
You may also be interested in an article from one of our readers explaining how $1 million can indeed last forever. Be sure to check out the comments from other readers – it is a great read (note that we are not accepting any more comments on the guest contributor article):
Copyright for this article belongs to Trish Power, and cannot be reproduced without express and specific consent.