In “Poor Richard’s Almanac,” Ben Franklin stated, “Never put all your eggs into one basket.” Most of us use this expression to remind each other that it is important to diversify. However, on occasion, the business owner operates contrary to that astute advice.
One of the American dreams is to have your own business so that you can control your own destiny, build equity in that company and ultimately use that business value as the sum and substance of a retirement nest egg. But, what percentage of your retirement strategy should the business represent?
Let’s examine a retirement planning strategy. What should be the value of the company for it to provide income and security for retirement? The questions should be: What total capital do you need to have accumulated by your retirement date? At what age do you want to retire? How much income do you want to live on monthly (use today’s dollars and inflate them at 4 percent to arrive at a dollar figure)? How long will you live? (IRS life expectancy charts project a couple aged 65 will live 25 years until age 90.)
Typically, entrepreneurs do not take the time to ask these questions; they’re busy doing their work. But because of their positive attitudes about their career paths, the businesses become their solution for future financial security. In the meantime, because of the risk associated with being in business, any available excess cash is placed in certificates of deposit or money markets to provide safety. The belief is that savings will offset the risk of investing in the business.
Let’s assume you’re a 45-year-old who desires to retire at age 65. After analyzing your monthly cash flow, you are surprised to learn that $6,250 per month is needed today to maintain an acceptable standard of living. So what does $6,250 per month have to be at age 65 to provide $75,000 of today’s buying power? At 4 percent inflation, you’ll need approximately $13,700 monthly in the year 2020.
What total must be accumulated to fund this $13,700 income need until age 90, adjusting yearly for inflation at 4 percent to maintain the same standard of living? What legacy/inheritance do you want to leave for your family?
How optimistic are you about Social Security and its ability to generate part of your required income? Let’s be optimistic and assume Social Security provides its projected $44,000 per year income to a 65-year-old couple which has contributed the maximum to the system. Your task now is to accumulate the capital to generate the $120,000 per year additional cash flow.
You may surmise that assuming a 10 percent net rate of return, all you need to achieve is a capital amount of $1.2 million net after taxes. How do you accumulate $1.2 million net balance? How much do you have currently in investments that you could dedicate toward this goal?
Or, is all your equity in your business? What portion of that $1.2 million should the business value represent and is the business liquifiable to translate that equity into cash or a consistent income stream?
Mathematically, assuming you have a $30,000 lump sum today and you add $1,306 per month to that account, at 10 percent net after tax, in 20 years you’ll have $1.2 million.
So in 2020, you retire and start living on $164,400. The following year, you need $170,976 to maintain the same buying power of $164,400 due to inflation. Even if we assume a Social Security inflationary increase of 3 percent, you’re broke at age 82. So what happened? Is $1.2 million enough?
The false assumption was that at 10 percent, $1.2 million could generate $120,000 annually. That worked for the first year of retirement, but inflation erodes the principal.
For this scenario to work, you need $1.725 million at age 65. A beginning balance of $1.7 million earning 10 percent net after tax, living on $164,400 gross annual income and receiving $44,000 (plus 3 percent annual increase) from Social Security allows your money to last until age 92 with an inheritance left to your family of $1.2 million.
In retirement planning, accurate projections are a necessity. Placing too much emphasis on the business equity alone could prove fatal. Robert A. Valente ([email protected]) is president of RAV Financial Services. He can be reached at (216) 447-3015.
