The trick to building lasting wealth, wealth you can live on forever and pass on to your loved ones, is to think of your investments as a personal endowment.
Just like at a college or a foundation, your personal endowment is a large pile of money carefully invested. Those investments generate income, and a portion of the income is reinvested in the endowment, while the rest of the income generates money on which you can live.
If the endowment is large enough, the income generated replaces your income from work. Then you have a beautiful retirement; in other words, you are free to spend your time doing whatever activities bring the most value to your life without having to worry about your next paycheck.
Why reinvest some of the income? To help maintain your purchasing power over time.
Inflation and market changes will erode the value of an endowment. For example, a bottle of Coke when I was a kid cost 25 cents from a vending machine. Now it costs $2 or more. That’s inflation. A quarter buys less today and will keep buying less over time.
If you want to maintain the purchasing power generated by your investments, your portfolio needs to produce an increasing amount of money.
To accomplish this, reinvest a small portion of the income generated by your endowment to keep the “principle,” or core assets, growing to match the pace of inflation. Once you take care of inflation, everything else you make is money to live off. But to do that successfully takes a lot of money.
For example, if you want to live comfortably on an annual income of $60,000 a year, your endowment needs to generate $60,000 of income, plus extra to reinvest. The typical rule of thumb for maintaining an endowment is never to withdraw more than 4 percent of the total value per year.
Since inflation averages around 2 percent to 4 percent per year, your endowment needs to generate 6 percent to 8 percent in returns. If you invest in a balanced, index-based portfolio consisting of 60 percent equities and 40 percent fixed income, your endowment should (hopefully) generate around 8.2 percent interest based on historical averages. That gives you 4 percent to withdraw, 4.2 percent to reinvest.
So how much money are we talking about? A lot.
If you want your endowment to comfortably generate $60,000 indefinitely, simply divide $60,000 by .04 or 4 percent. That’s $1,500,000. Ouch!
But it’s doable. Not easy, but doable. If it was easy, everyone would be doing it already. However, if you earn an average of $57,000 a year, save 15 percent pre-tax for 35 years at 8.2 percent interest, you’d have $1,608,107. It can be done!
If you earn more and save more, the time frame gets shorter and shorter. If you earn $100,000 per year, you’d need to save 15 percent pre-tax for 28 years to reach $1,544,016.
Simply divide the amount of money you want to live off annually by 0.04. That gives the total amount needed for your endowment. However, I’ve simplified a very complex process, which is why having a good financial adviser is essential.
Some investing nuances require continual adjustment, like the fact that there are no average years in the stock market or average years for inflation.
For example, the average mom has 2.4 children in her lifetime. But, there is no mother with 2.4 children; averages are tricky and potentially misleading. There are good and bad years in the market, but the averages are in your favor.
Sadly, many people never generate enough wealth to retire comfortably, so they delay retirement as long as possible. The shorter your expected lifespan in retirement, the less money you need because you can draw down the principle.
However, I always tell clients to never retire from something; always retire to something. Just quitting on life, with nothing to move toward, is one type of misery. Instead of looking to retire, can you re-fire your life? And can you do so with enough money in the bank to live comfortably and pursue a new adventure?