- What questions do you need to answer to help create a dream retirement?
- Three popular questions from readers
- Indexing your income protects your lifestyle
- Comparing today’s dollars with tomorrow’s dollars
- Beverley’s retirement income when retiring at age 65 with $1 million (7% investment returns) (3% indexation)
- Crunching the numbers: Retiring on $1 million (or $1.6 million)
Note: This article is a supporting article to the three-part series, ‘Crunching the numbers: a $1 million retirement (7% and 5% returns)’, ‘Low yields: A $1 million retirement on 3% or 2% returns, and ‘Crunching the numbers: a $1.6 million retirement’ (links for these articles are set out at the end of the article).
Before I receive dozens of emails stating that $1 million can indeed last forever, let me start with the following statement: If you live off only the earnings 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.
Important: Further, if you choose to use the superannuation system for your retirement plans, then you must withdraw a certain percentage of your pension account each year to receive concessional tax treatment (no tax) on your super pension account’s earnings.
This article explains the concept of ‘today’s dollars’, and highlights why allowing for inflation when planning for retirement ensures that you protect your desired standard of living when you retire.
Note: From 1 July 2017, you can transfer no more than $1.6 million into a superannuation pension account. If you currently have substantial assets in pension phase, that is more than $1.6 million, then you will have to move the excess back into accumulation phase (and pay 15% tax on earnings) or withdraw the excess from the super system. For more information on this new rule, see SuperGuide article Retirement phase: A super guide to the $1.6 million transfer balance cap.
What questions do you need to answer to help create a dream retirement?
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 articles How much super do you need to retire comfortably?and Setting a retirement target: Living on more than $60,000 a year).
- How long do you want this lifestyle? (see SuperGuide article Life expectancy: Will you outlive your retirement savings?)
- How much money do you have? (see SuperGuide article Financial freedom: Retirement planning in six steps).
- What investment return are you hoping to achieve on your savings in retirement? (see SuperGuide articles listed in the first bullet, and in the section Is my super fund performing? Note that in many of our wealth articles we provide annual incomes and lump sums using different long-term investment returns (2%, 3%, 5%, 7%), but you may have different expectations.
- Do you want to leave any money to your children? (see SuperGuide articles on death benefits, for example, Superannuation after-life: Beware the dastardly death tax, and the cap).
- Is there a gap between your expectations and what you hope to achieve financially for your retirement?
In January 2017, we updated and revamped our how much super is enough section of the SuperGuide website to reflect the January 2017 changes to the Age Pension rules, and to take into account the July 2017 introduction of a $1.6 million pension transfer balance cap. For more information on the government changes, see SuperGuide articles Age Pension: 300,000 Australians lost entitlements on 1 January 2017 and Retirement phase: A super guide to the $1.6 million transfer balance cap.
Our wealth articles are very popular articles on the SuperGuide website, especially our $1 million retirement articles (see Crunching the numbers: a $1 million retirement (7% and 5% returns) and Low yields: A $1 million retirement on 3% or 2% returns) and consequently I have received many emails challenging the fact that $1 million could ever run out when earning 7% after fees in a tax-free environment, and when receiving a certain level of income.
The confusion seems to be around withdrawing a flat level of income that doesn’t change for a 20-year or 30-year retirement, or withdrawing an income that increases in line with the cost of living (inflation). We have also updated the $1 million articles (and our $1.6 million SuperGuide article – see Crunching the numbers: a $1.6 million retirement) with an explanation of today’s dollars.
In collating the figures for the three features referred to in the 2 previous paragraphs, I relied upon the Australian Securities & Investments Commission’s MoneySmart retirement planner calculator. For an official response on the issue of whether a retiree could run out of money, I previously 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 earlier response to those questions, are set out below:
1. Reader question: Can you please explain to me how the million dollars of 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 SuperGuide table appearing later in the article.
2. Reader question: I just don’t get it. If I have $1.6 mil @ 7%, I generate $112,000 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].
For example, if you start at age 65 with $1.6 million, you can draw $83,895 income per year (indexed each year by 3%, and assuming an investment return of 7%) 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 $400,000* can deliver a couple nearly $60,000* (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 $23,000* per annum from the Age Pension (for a couple). That leaves about $37,000* per annum to make up. Trouble is, according to my calculations anyway, with a super balance of only $400,000, I can’t see a way to generate $37,000 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 $34,382* a year, while for a single person it is just under $23,000* a year. On an account balance of $400,000*, the MoneySmart Retirement Planner estimates the income (Age Pension + super) to be just under $60,000*, which includes a substantial PART Age Pension, or FULL Age Pension for many of those retirement years.
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 $400,000, along with a substantial part Age Pension, delivers just under $60,000 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, and that super savings run out at the end of the person’s 87th year.
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 4.0%. For example, if I have quoted a lump sum amount that will deliver $60,000 a year for 22 years, then that lump sum takes into account increasing the annual income by 3% a year, even though we quote $60,000 in today’s dollars.
The $1 million and $1.6 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 $1.6 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 $54,952 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 (assuming an investment return of 7% each year).
In today’s dollars, Beverley’s annual retirement income for each year works out to be $54,952 a year in today’s dollars (although significantly more in tomorrow’s dollars, that is, what she will actually receive each year).
Note: If Beverley’s retirement savings generated a 3% investment return each year (rather than 7%), then she can expect an income each year of $39,355 in today’s dollars until she is 100.
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 (after fees and taxes), then Beverley’s money should never run out if she only takes out $55,750 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. And they query why she is getting $39,55 a year if her savings are only generating $30,000 (3%) a year. What’s the story?
The ‘story’ is reasonably straightforward: If Beverley wants her lifestyle to be maintained, then taking out only $54,952 in 10 or 20 years’ time will not deliver her the lifestyle she wants. If Beverley withdraws $54,952 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. By the time Beverley is 87, she is receiving an actual income of more than $100,000, although in real terms it is worth $54,952 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 the ordinary calculator on my iphone to calculate the income Beverley needs to withdraw from your super pension each year in tomorrow’s dollars, to maintain today’s lifestyle of $54,952 (see table below), assuming 3% indexation/inflation. You can also do these calculations using an online calculator, such as ASIC’s account-based pension calculator (refer to Pension1 tab). For those wanting to manually calculate their future payments, simply multiply $54,952 (or your expected income) by 1.03%, and then multiplying that result ($56,601) 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 $54,952 in tomorrow’s dollars) and cop the fall in lifestyle later.
And answering the second question from Beverley’s friends: If her investments are only generating a 3% investment return, how come she can take out more than $30,000 (the investment return) from the very first year? Well, under the super pension laws she must withdraw a minimum amount, which is 5% of the account balance for a 65 year-old, which is taken into account in the calculator (you can use the calculator yourself to see how it works). And for the first 11 years of her retirement, she receives no Age Pension which seriously runs down her savings, but in the 12th year she receives a PART Age Pension and then from the age of 80 she receives a substantial Age Pension which becomes a FULL Age Pension from age 90, and allows her super savings to stretch a lot further. Thanks to the Age Pension, she can withdraw more than the earnings generated on her super savings in her earlier years, because of her Age Pension entitlements in later years.
Beverley’s retirement income when retiring at age 65 with $1 million (7% investment returns) (3% indexation)
|Age (receiving retirement income)||Tomorrow’s dollars (actual payments)||Today’s dollars (payments in real terms)|
|65 (retires today)||$54,952|
Note: Incomes in tomorrow’s dollars (using 3% indexation).
Crunching the numbers: Retiring on $1 million (or $1.6 million)
Due to popular demand, we have updated our 3-part special on what a $1 million lump sum can deliver you in retirement, and what a $1.6 million lump sum can give you as a single person, or a couple, and whether you retire at 56, or at 61 or 65, 67, or even 70. Click on the article links below:
- Crunching the numbers: a $1 million retirement (7% and 5% returns)
- Low yields: A $1 million retirement on 3% or 2% returns
- Crunching the numbers: a $1.6 million retirement
You may also be interested in an older 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):