Home > Articles

This chapter is from the book

Growth Targets—"The Magic 20"

Pretty much everyone likes to accumulate as much capital as possible. Some, obviously, succeed more than others. Spending patterns vary from individual to individual, family to family, and often by geographic location. However, the majority of families manage well if they accumulate an amount of capital that amounts to 20 times the amount of annual expenses that they incur—the "magic 20."

Why 20? Well, if you have 20 times as much capital as you spend each year, and you secure an annual rate of return on your investments of just 5% per year (generally achievable with minimum risk from instruments such as treasury bonds and the like), you will be able to maintain your ongoing living standard with minimal risk—at least for a relatively limited period of time (because a 5% rate of return is equivalent to one twentieth of your assets). It would, of course, be desirable to tack on something extra for the effects of inflation, at least until very late in life when you can allow your asset base to dwindle. It would be even more desirable if you could grow your assets after deductions for expenses, taxes, and inflation.

Inflation, incidentally, is no small matter. Money loses roughly one half its value every 16 years as a result of inflation. At age 60, Americans have an average life expectancy of approximately another 22 years. If you retire at 65, your retirement nest egg will be worth just about half its current value by the time you reach the age of 81. The income your assets produce, if they remain unchanged, will suffice to provide just about one half of the goods, services, travel, home expenses, and everything else that you could afford when you retired.

If we were to assume an average rate of inflation of 4% per year (actually higher than the past average) and an average tax bite of 20%, you would have to earn approximately 11.25% per year on your capital to make up for taxes and inflation if you require a true, inflation-adjusted 5% per annum stream of income.

Example

  • $1,000,000 asset base (required living expense income = $50,000)

  • You earn $112,500 or 11.25% on your investments.

  • Your tax bill comes to $22,500 (20% of $112,500).

  • This leaves you with $90,000 after taxes, of which $50,000 is used for living expenses.

  • You add the difference, $40,000, (4% of your initial asset base) to your asset base to enlarge it to compensate for the 4% rate of inflation.

Looked at in this way, the "Magic 20" should be changed, perhaps, to something closer to the "Magic 40 or 45."

  • + Share This
  • 🔖 Save To Your Account