Making Sure You Can Collect a Paycheck in Retirement
You’ve spent the last thirty plus years of your life building a nest egg. You watched your expenses, saved a fair amount each month, and used a good strategy to build up a 401(k) balance bigger than you would have ever imagined was possible. As the last person leaves the room from the retirement party, several revelations come to you:
- I do not have to come in to work next Monday!
- I am free to do what I want! and…
- I am not getting a paycheck next month!
The first two put you in a good mood. The third is not exactly what you wanted to hear. In this article, I’m going to take you through how to generate a paycheck in retirement. We’ll talk about wealth versus affluence, share a hypothetical example of one person’s path to a paycheck in retirement, speak a bit about accumulation versus decumulation, and finally talk about the process that you can use to actually draw a paycheck in retirement.
Historically, people received what was known as a “defined benefit” pension when they retired. It was exactly what the name implied – the company provided you a defined amount of pay (your pension) in your retirement. Changes in the business environment as well as the tax code have made defined benefit pensions increasingly rare. As a result, individuals now need to determine how to create and collect their own paycheck in retirement. In this article, I’m going to explain some key concepts that are critical in allowing you to collect a paycheck in retirement.
Wealth Versus Affluence
To start the discussion, we need to introduce the concepts of “wealth” and “affluence”. Many people are NOT aware of the difference between the two. It is absolutely critical that you understand the difference. In today’s world, you need to accumulate wealth if you wish to be affluent in retirement. We define these two concepts as follows:
- We can say someone is affluent if they have significant sources of income
- We can say someone is wealthy if they have significant amounts of assets
Most middle-class Americans are affluent during their working career, but many are NOT affluent during their retirement. That is because of the keyword “significant” in the above definitions:
- Significant is defined relative to your level of expenses
I am not going to give you a lecture on living within your means. Everyone understands that concept – although many choose to ignore it as can be seen from their credit card balances. What I am going to do is show you what is required for someone to be both affluent and wealthy.
Let’s start with wealth. One of my favorite measures of wealth comes from The Millionaire Next Door by William Stanley and Thomas Danko. They defined “under accumulators of wealth” (UAW), “average accumulators of wealth” (AAW), and “prodigious accumulators of wealth” (PAW) as follows:
- UAWs have wealth of less than “n” times their annual salary where n is an individual’s age in years divided by 20. For example a 45 year old would have an “n” of 2.25. If his income was $100,000, he would be an UAW if he had less than $225,000 of assets.
- AAWs have wealth of “A” times their annual salary where A is an individual’s age in years divided by 10. For example a 45 year old would have an “A” of 4.5. If his income was $100,000, he would be a AAW if he had more than $450,000 of assets.
- PAWs have wealth of more than “N” times their annual salary where N is an individual’s age in years divided by 5. For example a 45 year old would have an “N” of 9. If his income was $100,000, he would be a PAW if he had more than $900,000 of assets.
Two other ways to look at wealth accumulation:
- UAW’s have less than half as much wealth as AAW’s; and PAW’s have more than twice as much wealth as AAW’s.
- We can calculate what I call an individual’s “Wealth Accumulation Factor” (F) by the formula (assets / salary) divided by (age /10) :
- UAW’s have an F value less than 0.5
- AAW’s have an F value of 1.0
- PAW’s have an F value greater than 2.0
The first point above suggests that to become a PAW you need to be twice the accumulator an AAW is; and, you’re a UAW if you are accumulating at half the rate of the AAW. As we’ll see in a bit, doing twice as good as “average” when it comes to wealth accumulation is critical to guaranteeing your paycheck in retirement.
The second point above seems a bit more complicated, but in reality it is very easy to understand. Taking your assets and dividing them by your salary tells you how many years of salary you have saved. We want to compare that to your “age divided by 10”. This as the AVERAGE wealth accumulation level that you should achieve by a certain age (i.e. at 35 you should have 3.5 years of salary to be at the average level, at 45 you should have 4.5 years, and so on). The formula above creates a ratio that lets you know where you are versus the average level of accumulation. Hence if you have 3.5 years of salary saved and you are 35 years old, you are at the average.
Why is this important for retirement? Well, let’s walk through an example that will show us why becoming a PAW or getting to a “Wealth Accumulation Factor” of 2 is so critical:
- Assume Bob is 65 years old and he is about to retire.
- Bob has an annual salary of $100,000. He’s been saving 20% of his salary each year for a number of years and has $1.3M saved
- Bob is s a PAW as his “N” is 65 / 5 which is 13 and he has 13 * 100,000 = $1.3M saved.
- Bob has a wealth factor of 2 as (assets / salary) = 13, (age / 10) = 6.5, so his wealth factor is 13 / 6.5 = 2.
- Bob’s savings amount for this year was $20,000 (20% of his salary), Bob has been paying social security taxes of $8,000 per year, federal taxes of $17,000 per year, and state taxes of $3,000. This means that Bob “took home” $52,000 last year ($100,000 – $20,000 – $8,000 – $17,000 – $3,000 = $48,000) after accounting for taxes and savings.
So Bob essentially has a nest egg of $1.3M and he needs to generate an income of $52,000 per year. Looking at this from a percentage standpoint, we see that Bob needs to be able to withdrawal 4% ($52,000 / $1,300,000) of his portfolio to replace his take home income.
Those of you familiar with withdrawal strategies will notice that Bob’s required withdrawal rate of 4% is what is generally recognized as a “safe withdrawal rate”. The prevailing wisdom is that you should be able to withdrawal 4% of you nest egg each year and have an exceptionally good chance of being able to do so for 30 years. While there are some that will argue that the safe withdrawal rate is lower, it is a very good rule of thumb to use for assessing the amount of income that you can generate from your nest egg.
Affluence: The Feasibility of Building a Big Enough Nest Egg
Earlier we defined affluence as:
- We can say someone is affluent if they have significant sources of income
Provided that Bob retires with his $1.3M nest egg, and he’s able to withdrawal 4% from this nest egg, I would argue that he has ensured that he will be affluent in retirement.
The skeptics that are reading this will suggest that Bob’s situation is unrealistic and there is no possible way that you can reach this level of wealth. I could not disagree more. Bob can reach this situation by doing the following:
- He starts work at age 25.
- His initial salary is $15,000. He receives an annual raise of 5%
- Bob saves 20% of his salary and realizes a 7% return on his investments
The attached spreadsheet shows that if Bob follows the above path, he will retire at age 65 with $1,273,482.29 in his investment account – almost EXACTLY the $1.3M that is targeted to ensure he is able to withdrawal $52,000 per year.
A few important things here:
- The spreadsheet is set up to change assumptions on salary, tax rates, savings rates, and investment return rates.
- Bob’s required nest egg is based on his situation. Each individual’s situation will be different. The spreadsheet provided will allow you to examine your situation if you like.
I’d encourage you to spend a bit of time with the spreadsheet to examine your situation and see how changing the various factors affect your wealth factor. Remember the goal is to get to the “PAW” status of having a wealth factor of 2
As you work with the spreadsheet, you’ll gain some interesting insights:
- Your wealth factor at retirement is NOT effected by your starting salary – remember you are “only” allowed to spend your take home pay
- If you assume a HIGHER growth rate in your salary, you need to INCREASE your savings rate to maintain your wealth factor at retirement.
The key point to take away is that you can build the requisite nest egg for affluence in retirement. However, it requires that you have the discipline to save (20% of your salary is a good rule of thumb) and to live within your take home pay.
“Cutting” Your Paycheck
That brings us to the final topic, how is Bob going to convert his wealth to income? Simple, Bob is going to “set up” a paycheck for himself. To get the $52,000 he needs annually, he needs a paycheck of $4,333.33 each month. Bob can set up a monthly withdrawal from his assets in the amount of $4,333.33.
Many folks struggle with this concept. That is because for years, the flows in their retirement account have always been “IN TO” as opposed to “OUT OF” the account. Psychologically pulling money from this account is very uncomfortable. In addition, people often struggle with the actual mechanics of which investments should be sold AND how to physically move the funds from their retirement account to their checking account. Let’s take each of these topics in turn.
To determine which investments to sell to generate cash for your paycheck, you should look to your asset allocation strategy. Each of your investments should have a targeted asset allocation. You use the assets that have an allocation ABOVE their target to generate cash for your paycheck. Those familiar with rebalancing will recognize this concept readily. Those that are not familiar with the concepts of rebalancing should reach out to their accounting or financial planning service provider for help on this topic.
Regarding the actual movement of funds, this is normally quite easily accomplished via a phone call to the customer service desk of the entity that holds your retirement account. In today’s environment, most service providers are very well versed on establishing automatic transfers and can help you set up the process.
Hopefully after reading this article you have a better understanding of what is required to ensure that you are able to continue to receive a paycheck in retirement. By implementing a disciplined savings plan during your working years, you will be able to accumulate sufficient wealth to ensure that you can continue to live an affluent life style in retirement. Finally, if you have any questions about the topics covered in this article, feel free to reach out to me at any point in time. I enjoy working with entrepreneurs, corporate executives, and families to define their goals and make sure they have plans in place they are executing to achieve those goals.
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