There are many ways that we measure wealth, and many ways that we can fund our retirement through our wealth.
One way to measure to determine where we are in terms of our savings is to look at months of covered expenses. For example, if a couple had $600,000 in net worth (assets minus liabilities), and $4,000 in monthly expenses, then they are 150 months wealthy in terms of savings.
Covered expenses is a simple, practical way for many of us to assess where we are financially. I’m a big fan of this personal finance diagnostic tool. It tells us how long we can live on what we have saved. Most of us are not multi-millionaires who can live off interest income and not touch our principal. Some folks reading this might be in that position, but if the rest of us stopped working, we would have to use our savings. This approach tells us how long our savings will last.
Stretching our minds and looking at things differently, perhaps we can save money with the intent of accumulating year in, year out, and never spending your savings. Keep on saving it, even when your months of covered expenses exceed your estimated remaining lifespan.
Why? Well, not touching savings is not just letting money sit there. Rather, it’s repurposing the money to be used as a source of more money.
This is where portfolio income comes into play. Instead of consuming your savings, you preserve your savings and let your money work for you. It becomes your faithful source of your own personal social security check.
Lets say the couple with $600,000 wants to live off an income stream without touching the principal. One could look at the required rate of return to see how how hard this money needs to work in order to satisfy their expense needs.
Taking a conservative view of returns, however, one could try to backsolve for the required nest egg size they would need to accumulate in order to live on their income stream.
For example, if the couple wanted to live on $4,000 monthly – $48,000 annually – they would have to amass quite a nest egg. If you took $48,000 and assumed a 3% rate of return to match inflation, it would take a next egg of $1.6 million for them to live on that $4,000. If they reduced their expense needs to $3,000 per month, it would take a nest egg of $1.2 million for them to accomplish the same goal.
This specific example doesn’t factor in the idea that your principal will reduce in purchasing power every year due to inflation. Remember that a dollar today is worth more than a dollar tomorrow. That said, portfolio income is cash flow that you can rely on without directly touching the principal. The good thing is, if you need that, you can eventually tap that as well. It’s another layer of conservatism is making sure you have enough to live on.
Ultimately, my take is that by working toward portfolio income, while trying to leave the principal intact as much as possible, you’re taking a big step toward financial freedom.
You will have worked hard to save and grow your money. Allow it to reciprocate and work hard for you in return!
Any thoughts? Do you look at retirement savings in terms of income streams, or in terms of a lump sum to tap into?
One note: I am personally a long, long way from retirement. Not going to stop me from dreaming big though:)