The Million-Dollar Retirement Question

One question I’ve received several times over the years is what I’ve jokingly called the “million-dollar question” to my wife. It comes in several variations, but generally boils down to two types.

The question is either this one:

How much would I need in the bank to live the rest of my life on the interest?

Or this one:

If I had a million dollars, what would I do with it so I could live forever on that money?

I combined the two into a single question: Could I live for the rest of my life on $1 million – and if so, how?

It’s a really good question, but it’s a tricky one to answer. For starters, there are a lot of different ways to invest $1 million. If I use a bunch of different methods in my example, it’s hard to come up with a clear answer. Also, past performance of investments don’t necessarily indicate future returns, so no matter what I do, it won’t be perfectly accurate.

Instead, what I decided to do was to use two sets of historical data – the last 25 years of the S&P 500 and the last 25 years of the Consumer Price Index.

The S&P 500 serves as the benchmark for investment returns in this model. I’m basically assuming that the person put all of their money into the S&P 500 at the start of this. I’m also assuming that the S&P 500 is returning an additional 1.5% in value in the form of dividends which the person is spending first before tapping their actual investments. I could use dividend historical value, but the historical data shows that the yield rate of dividends overall is slowly going down over time, so I’m using that 1.5% as a “forward-thinking” number.

I’m using the Consumer Price Index as our basis for inflation, using the annual percentage change to calculate how much more money I’ll need to pull out each year.

This brings us to the real question: how much do we need per year to live on? For this exercise, I’m starting with 80% of the average annual household income data from the Census Bureau. The average annual income from the most recent census data is $55,030, so 80% of that is $44,024.

Let me use the first year as an example of how I’m calculating this.

So, at the start of the first year, your investment is worth $1,000,000. Over the course of that year, several changes are going to happen. First, you’re going to earn 1.5% of that value in dividends – $15,000. Next, the value of that $1,000,000 is going to go up based on the historical value of the S&P 500 from 1990 (remember, we’re using the S&P 500 from the last 25 years to estimate the future of the S&P 500). In 1990, the S&P dropped by 3.06%, which means that $1,000,000 went down by $30,600, leaving us at $969,400. However, our annual income needs are going to go up by an amount equal to the Consumer Price Index change from 1990 (again, we’re using that historical data to model the future), which was 6.1%. So, our income needs went from $44,024 to $46,709.46. $15,000 of that came from dividends, as calculated above, so we need to sell $31,709.46 in stocks to make up for this. This leaves us with $937,690.536 at the end of the first year. Ouch. At this pace, you’re broke in twenty years. However, it’s worth noting that this particular year was a relatively rough one for the stock market and had high inflation.

(Yes, that last paragraph was wordy, but I’m essentially walking you through the calculations that I did, step by step. From here on out, we’ll stick with end results).

However, in the next year (which mirrors 1991), the S&P 500 went up by 30.23% and the CPI only went up by 3.1%. At the end of that year, you’ll pay for all of your living expenses and your final balance will be $1,187,062.29.

If you do this for twenty five years, mirroring every year from 1990 to 2014, you’ll actually end up with $7,861,850.23.

That seems amazing. Not only will all of your living expenses be covered, your wealth will simply grow by leaps and bounds. In that situation, you should absolutely retire if you have $1,000,000 saved.

But are our assumptions good ones?

Over that period, the S&P 500 averaged a 11.13% return per year. On the other hand, Warren Buffett suggests a 6% to 7% annual return in the future. What happens if we replace that S&P 500 historical data with a 6.5% annual return as predicted by Buffett?

Well, in this case, with $44,024 in annual spending that grows at the rate of the Consumer Price Index, a 6.5% annual return, a 1.5% dividend, and the last 25 years of CPI data, after paying for all of your living expenses, your final balance after 25 years will be… $2,570,667.92. That’s still pretty fast growth and I’d encourage people to do this if this were true.

Still, are we being too optimistic here? What if you needed to spend 100% of an annual household income – $55,030 instead of $44,024?

Well, under those conditions, with $55,030 in annual spending that grows at the rate of the Consumer Price Index, a 6.5% annual return, a 1.5% dividend, and the last 25 years of CPI data, after paying for all of your living expenses, your final balance after 25 years will be… $1,501,216.11. You’re still ahead by a little, but not overwhelmingly so.

How about another modification? Buffett’s prediction included an estimate of 2% annual inflation, so what if we used that instead?

Under those conditions, with $55,030 in annual spending that grows at 2% per year for inflation, a 6.5% annual return, and a 1.5% dividend, after paying for all of your living expenses, your final balance after 25 years will be… $1,976,461.479. It turns out that Buffett’s prediction is actually a little better than the last 25 years, at least in terms of inflation.

What all of these predictions show us is that if we use historical data or realistic predictions for the future from economic experts, $1,000,000 is enough for an average person to live on for the rest of their life. However, there are still a few caveats.

First, this assumes that we don’t have some sort of major economic collapse. Even in the deepest recessions, our economy has been pretty good since the start of World War II, but that’s not a guarantee that it will always be strong. You can make it on $1,000,000 if the economy is the same as it’s been over the last 25 years or even a little weaker, but you won’t be able to do it if things are much weaker.

For example, with $55,030 in annual spending that grows at 2% per year for inflation, a 3% annual return, and a 1.5% dividend, after paying for all of your living expenses, your final balance after 25 years will be… actually, you’ll be broke after 24 years. Living forever on $1,000,000 relies on a a stock market only slightly weaker than we’ve had for the last several decades. If it’s much weaker than that, you won’t make it.

It also assumes you have good self-control and good insurance. Good self-control keeps you from tapping any of your balance to buy things you might want, like a house or other things of that nature. Good insurance keeps you from losing that money due to an unexpected event, such as a severe illness or an automotive accident.

In the end, we’re still left with the real question: If I have $1,000,000, can I retire?

Having run the numbers, my reaction is that if you’re planning on doing something productive in retirement and you built your wealth through personal effort and self-control, you’ll be fine. For example, if you slowly saved up that million dollars and have thus demonstrated your self-control and ability to make good choices and you’re planning on spending your time writing novels or working for a charity, you’ll probably be okay.

On the other hand, if this money was a windfall and you haven’t given yourself time to figure out if you have that self-control yet, keep working. Put that money aside and watch how you actually use it. If you find yourself continually dipping into that money – even just a time or two a year – I’d suggest not retiring early at all.

In other words, your self-control is the biggest factor. If you can live on a reasonably small income without being constantly tempted to tap the large savings you have, you’ll probably be okay.

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