You’ve built up your $1 million retirement war chest and you’re ready to roll, right? Now imagine you saved an additional $40,000 so you could delay tapping your retirement savings for just one more year.
By living off that $40,000 instead of withdrawing the customary 4% from your portfolio in the first year, you could add more than $1 million to your retirement assets. Let me show you how.
In my two most recent columns, I described hypothetical retirement income streams for various combinations of asset allocation — how much you hold in stocks versus bonds — and different withdrawal rates, such as 4% versus 5%.
Those examples assumed you retired at the end of 1969 and began withdrawals from a $1 million portfolio at the start of 1970.
Now let’s change one key assumption. Suppose that in addition to your $1 million portfolio, you saved enough money to cover your first year of retirement expenses — in this case, $40,000.
Many conservative investors like this idea, worried that the market might decline during their first year of retirement.
Mathematically, saving this extra $40,000 is similar to delaying retirement by one year, because you wouldn’t begin withdrawing from your portfolio until January 1971.
That single change allows your portfolio to keep growing uninterrupted — and over decades, that growth really adds up.
How $40,000 becomes more than $1 million
When I saw the numbers in the table modeling this scenario, I was surprised by how much additional growth a “mere” $40,000 could produce.
To make the comparison clear, I looked at two tables: one assuming the extra $40,000 (the “new” table) and one without it (the “old” table).
Using a conservative allocation — 40% diversified equities and 60% bond funds — the old table shows that after 43 years of retirement withdrawals, the portfolio would be worth $5,012,712.
In the new table, with the additional $40,000 saved up front, the portfolio’s value at the end of 2012 rises to $6,392,098.
That’s a difference of about $1.38 million.
Did this extra money change the retiree’s annual lifestyle? Not at all. The yearly withdrawals were identical in both scenarios. For example, in 1980, each retiree had the same $81,455 to live on.
So what’s the big deal?
There are four powerful answers.
First, the extra $1.4 million represents a dramatically larger legacy for family or charities.
Second, the larger portfolio provides a much greater margin of safety throughout retirement — something conservative retirees value deeply.
Third, that extra cushion creates flexibility. With the added security, the retiree could reasonably increase equity exposure.
For example, in the new table, a 50/50 stock-bond portfolio ends 2012 at $10,626,205, compared with roughly $6.4 million under the conservative 40/60 allocation.
That’s effectively turning $40,000 into $4.2 million.
An even better possibility
So far, we’ve assumed the retiree never spends any of this extra cushion. But after a few years, the portfolio may be strong enough to support higher withdrawals.
Assume the retiree sticks with a 4% withdrawal rate for the first 10 years. By the end of 1979, the portfolio would be worth $1,608,174 — well above the initial $1,040,000.
At a 4% withdrawal rate, that produces $81,455 to spend in 1980.
If the retiree instead switched to a 5% withdrawal rate at that point, still adjusted for inflation, annual income would rise to $101,819.
That’s a 25% raise — an extra $20,364 in a single year.
That one-year increase alone equals more than half of the original $40,000. And each future year’s withdrawal would rise accordingly.
In addition, the retiree would still end up with a much larger legacy at the end of retirement.
The takeaway
To my mind, this may be the best possible use of $40,000.
It’s worth working a little longer. It’s worth saving a little more. It’s worth planning for — and it’s worth doing.
Richard Buck and Larry Katz contributed to this report.