For some people, $5 million may be enough to retire comfortably. But your risk tolerance, preparation and goals – and sometimes a little bit of luck – may affect the long-term success of this plan. You need to consider portfolio allocations, budget and worst case scenarios to build a resilient plan that can withstand market downturns, inflation and other unknowns.
Discuss your retirement plan with a financial advisor to see where you stand.
Projecting Retirement Funds
To decide whether you can retire by 40 when you have $5 million, you can use typical investment returns and inflation rates to help get a better picture. By applying the balance of your retirement and investment accounts to typical return rates for your portfolio allocations and projected inflation, you can project the growth of your net worth – minus the loss of purchasing power that comes with time.
For example, you might assume an average 8% annual return on your investments. This is a middle-of-the-road return for a diversified portfolio of stocks, bonds and cash. At this rate of return, $5 million will generate $400,000 in the first year. If you employed a more conservative 4% withdrawal rate, you could withdraw up to $200,000 the first year.
Over time, inflation eats away at the value of money, so the withdrawal rate may be adjusted. While a 2% inflation rate is a reasonable assumption, inflation may vary significantly from year to year. But over time, 2% will likely be close to the actual average rage. With this in mind, the second year’s withdrawal would be $204,000. And it would increase by 2% each year thereafter.
Given that you are withdrawing less than half the projected annual earnings, if these assumptions prove correct, your retirement nest egg is not likely to ever be fully emptied. And that’s no matter how long you live. Of course, there’s no guarantee any of these assumptions will turn out to be what actually happens.
Monte Carlo Simulations
In order to recognize this uncertainty and plan as well as possible, retirement planners may use Monte Carlo simulations. These are mathematical models that assign random values to important variables. This includes inflation and investment returns. And then it determines how frequently various outcomes occur.
For instance, consider a Monte Carlo simulation using a $5 million starting nest egg and a portfolio allocated 50% to domestic stocks, 40% to domestic bonds and 10% to cash. Basing returns on the historical record, this scenario looked at average investment gains ranging from 6.10% – the lowest-performing 10% of scenarios – to 9.31% – the highest-performing 10% of scenarios.
This simulation found that in 75% of cases, a withdrawal rate of 4.07% would allow a 40-year-old retiree to still have a positive account balance of approximately $4.7 million, unadjusted for inflation, even after 60 years of withdrawals. This assumes a rate of return of 6.91% annually and an average annual inflation rate of 2.79%.
These simulation results don’t mean you are guaranteed to never run out of money if you retire at 40 with $5 million. For instance, if average annual returns amount to just 6.1%, which is the bottom 10% of historical return rates, your portfolio would be emptied before age 100 if you withdraw 4% each year.
To be fully safe from ever running out of money, according to this worst-case simulation, you would have to limit your withdrawals to 3.03% of the account, or $151,500 the first year.
Caveats About Retiring At 40
If you stop working at 40 you will be a couple of decades ahead of most people’s retirement. While that leaves lots more time to enjoy being free from the need to work to earn money, there are some caveats and limitations that go with a plan like this.
Social Security is one consideration. If you stop working at age 40, you likely will not have worked long enough to earn enough credits to qualify for Social Security. These inflation-adjusted monthly benefits represent an important source of income for most retirees.
You become eligible for Medicare, the national government-sponsored health insurance plan, at age 65. You don’t need work credits to get Medicare, but the age requirement means you’ll have to fund your own healthcare, including insurance premiums and out-of-pocket payments, for a quarter-century. This can potentially be a sizable amount, depending on your healthcare needs.
Retiring at age 40 is entirely feasible if you have accumulated $5 million by that age. If the long-term future is much like the long-term past, you will be able to withdraw $200,000 the first year for living expenses and adjust that number up for inflation every year more or less forever without running out of money. There are few guarantees, however, and in some circumstances you may have to get by with less retirement income.
Retirement Savings Tips
- A financial advisor can help you design a retirement savings and investment plan to fit your means and your needs. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- SmartAsset’s Retirement Calculator will tell you how much you need to save in order to have enough for retirement. It takes into account your location, age, current savings balance, how much you plan to contribute and what your post-retirement income needs will be.
Photo credit: ©iStock/PeopleImages, ©iStock/PeopleImages, ©iStock/fotostorm