On more than one occasion, I have heard a proposed scenario similar to the following: "I need $50,000 per year for my living expenses. If I had a $1,000,000 investment that would earn just 5% annually, I could live off the $50,000 earnings each year and never touch my $1,000,000 principal investment." The flaw with this proposal is that it does not consider the effects of inflation. Although an individual might might only need $50,000 for living expenses this year, inflation will likely cause that person's annual need to increase above $50,000 in future years.
Let's say the rate of inflation averages 3% per year. If you require $50,000 in year one, and the cost of living inflates by 3% the following year, then your cost of living will be $51,500 in year two. The $1,000,000 would produce $50,000 of earnings in year two that you would withdraw, but you would also need to withdraw $1,500 from the principal balance to cover the increased expenses in year two. In year three, your cost of living inflates by another 3% to make your expenses total $53,045. Also in year three, the principal balance has been depleted by $1,500 to a current balance of $998,500. Assuming the investment earned 5% again, you would have earnings of $49,925 in year three. You would withdraw the $49,925 earnings plus $3,120 from the principal to cover the increased cost of living. As you may start to detect, this process compounds every year, and you keep taking more and more from the $1,000,000 initial balance.
If a person wants the "living off the earnings" proposal to work, an assumption needs to change. The proposal above uses a nominal rate of return of 5%. The proposal should use a real rate of return, also know as an inflation-adjusted rate of return. The real rate of return is NOT calculated by subtracting the inflation rate from the investment growth rate, such as 5% growth minus 3% inflation to equal 2% real return. I have seen some sources incorrectly calculate the real return that way. The real rate of return is CORRECTLY calculated as one plus the nominal rate divided by one plus the inflation rate, then subtracting one from that result. Here is how the real return would be calculated in the previous example:
{ [ (1+.05) / (1+.03) ] -1} = 1.94%
Let's now revisit the proposal considering inflation this time. If I had a $1,000,000 investment that would earn at least 5% annually, and inflation equals 3% annually, I could live off $19,400 of the earnings each year, adjusted for inflation, and never touch my $1,000,000 principal investment. The $19,400 is calculated by multiplying $1,000,000 by a 1.94% inflation-adjusted return. Alternatively, let's say I want to determine what principal balance amount I need to support $50,000 of annual living expenses without breaking into the principal balance. I calculate this number by dividing the $50,000 expenditure need by the 1.94% inflation-adjusted return. In this example, I would need a principal balance of $2,577,320 in order to support annual living expenses of $50,000, adjusted for inflation, without needing to withdraw anything from my principal balance.
To this point, I have only considered inflation in calculating the real rate of return. However, taxes should also be considered. Assuming the investment is taxable, the investment earnings will not be completely retained. When considering taxes, the more relevant performance measurement is the after-tax return. The after-tax return is a little more simple to calculate than the inflation-adjusted return. It is calculated by multiplying the investment growth rate by one minus the tax rate. For example, if my investment produced 5% earnings, and I paid 15% tax on those earnings, my after-tax return would equal 4.25%, calculated as follows:
[ .05 X (1-.15) ] = 4.25%
All investment performance evaluations should compare the real rates of return. A non-taxable investment may have a lower nominal return, but it might be the more favorable investment option for a person in a high tax bracket. Although the nominal return of a taxable investment may appear more attractive, we must consider taxes in the real world. Adjusting a nominal return for both inflation and taxes can result in a significantly reduced real return, but the real return should always be considered when we want to avoid falling short in our projections.
