Is Your Nest Egg Large Enough? Calculate the Required Rate of Return

Have you saved enough for retirement, and your future financial needs?

As much as I would like to say that I have done so, I’m a long way from that point. In fact, I’m not even remotely close. I’m actively working on it though, day by day, focusing on growing the income minus expense gap. I’m guessing that if you’re reading this, then you’re probably somewhere on that same journey as well.

Since we know that we aren’t there yet, just how close are we to actually being able to retire? What is health of our portfolio, and how do we measure that?

One could take the traditional approach, and focus on net worth, calculated as assets minus liabilities. I have advocated taking this a step further by calculating months of covered expenses, to determine just how long you can survive based on your current net worth and expense needs.

I often look for different ways to answer such questions, with the hopes that some additional insights could be gained by viewing a situation through a different lens. In this case, determining where we are with respect to being able to retire, I suggest that we also consider our current required rate of return.

So, what is the current required rate of return?

In essence, it is the rate of return that we will need to earn, in order to survive with our current nest egg. 

Let’s assume a couple with the following financial profile:

Assets: $800,000

Liabilities: $200,000

Monthly Expenses: $4,000

Further, let’s assume the following additional information:

Tax Rate: 25%

Rate of inflation: 3%

To calculate their required rate of return, let’s first subtract liabilities from assets to obtain net worth:

Net Worth = $800,000 – $200,000 = $600,000

Then, let’s annualize their expenses:

Annualized Expenses = $4,000 x 12 = $48,000

Next, calculate percentage return on net worth:

$48,000 / $600,000 = 8.0%

So, this means that the couple needs to earn 8.0% on their nest egg to meet their expenses. Or so it seems.

The 8.0% figure is an interim step. There are two more factors that need to incorporated:

1)      Inflation

2)      Taxes

To account for these factors, let’s take these steps:

1)      Rate of return adjusted for inflation = 8.0% + 3.0% = 11.0%

2)      Adjusted rate of return, pre-tax = 11.0% / (1-.25) = 14.67%.

Thus, on a pre-tax basis, the couple’s portfolio must return 14.67% annually in order to meet their annual expenses.

Here’s the formula:

1)      Return on net worth = annual expenses / net worth

2)      Required return = (return on net worth + inflation) / (1 – Tax Rate)

What insights can we get from this calculation?

1)      The ability of the nest egg to meet income needs. In this case, when you see a required rate of return at 14.67%, it tells you that you likely don’t have enough saved!

2)      Direction on reallocating our investment mix. In this case, with this type of required return, one might want to consider a mix of assets that is more likely to obtain a higher return. With higher potential return comes higher risk. And closer to retirement age, that might not be such a good thing. But it’s something to consider.

3)      Information on how we can improve our balance sheet and cash flows. Taking this formula, we can make changes to net worth and expenses to see how increasing/decreasing these measures can help us meet our goals. For example, in this case, reducing expenses to $3,000 per month and boosting assets by $200,000 changes the required rate of return to 10.00%.

It’s interesting to view the health of our portfolio using different calculations. What I like about this one is that it incorporates taxes and inflation, which many more basic views don’t.

Any thoughts? Do you have any other measures for assessing the ability of a portfolio to meet future cash flow needs?

This article was included in Carnival of Personal Finance #260 at Rainy Day Saver.