How To Retire With $1.5 Million Starting At 40

How To Retire With $1.5 Million Starting At 40

Let’s say you just turned 40. Obviously, 40 is just a number, but in many ways, it’s a milestone. Though people are living longer these days into the 80s and 90s, still age 40 is considered the halfway mark. On the brighter side, you are mature, stable, financially savvy, and likely well settled in your career. More than likely, you are making much more money than when you just started. But then your life expenses have gone up even at a faster rate, saving is always a tough challenge. It’s quite probable that you have experimented with stocks and other investments and, in the process, made some good as well as bad decisions. But most importantly, you have learned lessons from those costly mistakes.

Nonetheless, if you have not saved much or anything at all until you got to 40, there’s no need to panic or stress about it. You just need a strategy and will to implement it. The first thing is to commit to saving aggressively, which obviously would demand a bit of sacrifice on your current lifestyle. You need to be serious about it now, and delaying it any further can make meeting retirement goals increasingly difficult, if not impossible.

Importance of Starting Early

If you already are a seasoned investor (and saver), you could skip this para and the following example (Table-1 and Table-2). Otherwise, if you are into your 30s or even 20s, and reading this, we cannot emphasize enough about the importance of starting saving and investing early. However, most of us do not have this wisdom at the age of 25. In your early stage of working career, the thought of retirement appears to be so distant and elusive that so many people fail to accord any priority to savings and investing. It goes without saying that saving and investing at a younger age goes a long way in meeting retirement goals without stress or much sacrifice. Only if we all could get this wisdom in our 20s or 30s, but it does not happen to a vast majority of us.



Just for the sake of illustration, we will show our favorite example. Two friends, John and Jim, start working their full-time and similar jobs at the age of 25. John started saving and investing right from the first year and putting aside $250 a month in his investment account. He also increased the rate of his savings by 3% every year. By saving and investing this modest amount every month, and assuming an investment return of 8% (average over the span of 37 years), John would have a balance of over $1 million by the age of 62. Sure, the value of $1 million after 37 years will not be the same, and John will probably need to save more, but we will get to that point later.

His friend Jim does not see the importance of saving and investing and does not have this sense of urgency until he gets to 40 years of age. Let’s see how much Jim will need to save every month (starting at 40) to get to a goal of $1 million by the age of 62.

Table-1 (below): Starting at age 25, saving $250 every month, and increasing it by 3% every year, John hits the target of $1 million at age 62.

Table-1:

[Source: Author/Financially Free Investor]

Note: To keep the table small in size and presentable, only rows with a gap of five years are being presented.

Table-2 (below): Jim starts saving at age 40, with no prior savings. If he starts with the similar amounts as John (see table-1, $389 every month at age 40) and increases it by 3% every year, assuming the same 8% investment return, his savings will only grow to $393,000 by age 62. He would achieve less than 40% of the goal. To be able to achieve $1-million target while starting at age 40, Jim must save $1,000 every month starting age 40, increase it by 3% every year. This is 2.5 times larger amount every month compared to John, who started at age 25.

Table-2:

[Source: Author/Financially Free Investor]

It is important to note that the purchasing power of $1 million after 37 years would not be the same as it is today. So, a 25-year-old today should probably aim for 2.5 times or as much as $2.5 million to retain a similar purchasing power as of $1 million today (assuming an average rate of inflation at 2.5% for the next 37 years). That means if John is starting today, besides saving $250 a month, he also should save at least 6% of his income in a tax-deferred 401(k) account and increase it gradually over the years.

Also, what about the assumption of 8% consistent sequential returns? Is that achievable? Some folks would argue that it is not. We agree that it may not be very practical for a short time frame. However, we are talking of a very long horizon of 22 to 37 years in the above examples. Also, to be able to achieve 8% or higher annualized returns, one needs to follow a highly-disciplined approach. The problem arises when someone does not have the right temperament to ride the market in good times as well as bad. As such, an 8% average-return is less than the long-term average of stock market returns. If we like to be more conservative in our assumptions, we just need to save more to be on the safer side. We also provide a strategy in the second part of this article that we think should help achieve 8% (or even better) annualized returns.

You turned 40; It’s Time to Plan A Strategy and Implement

Let’s consider two scenarios:

  • You already saved $100,000 by age 40, somewhat similar to John in example 1 above. You recognize that $1 million may not be enough after 22 years, and you want to save at least $1.5 million, but preferably more. To reach your goal of say $1.5 million by age 62, all you need is to save 6% of your gross family income (assuming 100,000 of family income), provided the capital grows at an 8% annualized rate. However, to achieve a target of $2 million, you may have to save 8-9% of your gross family income. This also will help to achieve the same overall results even if your projected annual returns were more modest at 7% rather than 8%.
  • Let’s assume you followed Jim’s example and you have not saved enough until you got to 40. However, as we have said before, there’s no need to panic, as that does not help solve the problem. You still have plenty of choices. All it needs is a strong determination to save more now and invest wisely to get at least 8% average yearly returns. Since you have not saved much until now, to reach your goal of $1.5 million, you will need to save much more aggressively than the first option, maybe as much as 13-15% of your gross family income, assuming 100,000 of family income.

Scenario-1:

Assumptions:

Note: We will discuss how to achieve 8% growth in the next section of this article. Also, the saving rate should preferably be more like 8% to compensate for any shortfall in growth/returns.

Table-3:

[Source: Author/Financially Free Investor]

Note: To keep the table small in size and presentable, rows with a gap of five years are being presented.

Scenario-2:

Assumptions:

Note: We will discuss how to achieve 8% growth in the next section of this article. Also, the saving rate should preferably be more like 15% to compensate for any shortfall in growth/returns.

Table-4:

[Source: Author/Financially Free Investor]

Note: To keep the table small in size and presentable, rows with a gap of five years are being presented.

Sample Portfolio Construction

How to achieve an average of 8% (or more) yearly return:

We believe that to be truly diversified, you need to invest with a multiple bucket (basket) approach, each bucket invested in a different strategy. Since each strategy would have unique goals and risk factors, it can provide some level of hedge during the times of market stress. As such, investing has become very easy for ordinary folks in terms of online brokerage accounts, zero commissions, and online research resources. However, on the other hand, investing successfully and growing money have never been easy, and it is not so today. While we all want a high rate of return on our investments, preserving the capital from big losses is critical to long-term success. Depending solely on index investing may turn out to be a bit risky, volatile, and bumpy. That’s why, in our view, it’s important that we employ a few strategies.

For the purpose of this portfolio construction, we will use three investment-buckets:

  • DGI portfolio -> 35-40% of assets

Basically, this strategy is a buy-and-hold and invest in large, blue-chip companies that are growing their dividend at a fast clip. The overall growth goal will at least be 9-10%. By the time of retirement, this portfolio will provide a large sum of dividend income, without the need to sell any shares.

  • Risk-Adjusted Rotation Portfolio (401(k) accounts) -> 35-40% of assets

This is our hedging, as well as the growth bucket. This will help us keep our sanity whenever the market throws a big tantrum, or there is a multi-year recession. But while the main purpose of this portfolio is to provide hedging, it’s no laggard when it comes to growth.

  • High-Growth Portfolio -> 20-30% of assets.

Since this portfolio is for a 40-year old with plenty of time left to compound, we need to take some measured risk to attain high growth. This bucket will invest in high growth stocks in sectors like Technology, Financials, and Biotechnology.

Bucket 1: DGI Portfolio (35-45% of Assets)

Some may argue that why a 40-year old would need dividend stocks since they do need the income today. But we know that a DGI (dividend growth investing) portfolio needs time to grow its dividend. Usually, you would start with a low portfolio yield, but over time it would grow significantly. In 20 years, a dividend portfolio can easily compound its dividend yield (on cost) from a low of 3% to as much as 10% (on a cost basis, not on market value).

One could select 20-30 large, blue-chip companies with a solid history of paying and growing dividends. Since we are designing this for a 40-year old, we should include many companies that may have low current yield but high growth rates of dividends, for example, Mastercard (NYSE:MA), Home Depot (NYSE:HD), Microsoft (NASDAQ:MSFT), Amgen (NASDAQ:AMGN), and Texas Instruments (NASDAQ:TXN). An overall starting yield of 2.5% to 3% for the portfolio should suffice, which would grow to at least 8-10% yield on cost in the next 20 years.

This bucket could be implemented inside your IRA/ROTH-IRA or taxable-brokerage accounts. However, this bucket could be inside your 401(k) accounts as well. If you are solely investing in a 401(k) type of account, which is managed by your employer (or employer-sponsored fund company), it may or may not allow investment in individual stocks. However, many of the employers have contracted this out to companies like Fidelity, which in turn allows investing a certain portion of your assets in individual stocks in a brokerage type account.

Below, we provide a sample selection of 20 stocks (table sorted on sector/industry) for demonstration purposes. We assume that the dividends will be re-invested either in the original stocks or in new stocks.

List of 20 Stocks:

(ABBV), (AMGN), (AMT), (AOS), (ATVI), (AVGO), (AWK), (COST), (HD), (JNJ), (LMT), (LYB), (MDT), (MSFT), (NEE), (PEP), (TSN), (TXN), (UNH), (UPS)

Table-5: (Stocks sorted on the industry)

[Source: Author/Financially Free Investor]

Bucket 2: 401(k) Account Strategy (Roughly 35-40% of Assets)

Let’s face it. At 40 years, much of your savings (or future savings) will be tied to your employer-sponsored 401(k) plan. Some of the 401(k) plans offer only a few mutual funds and/or ETFs. Fortunately, most of them offer at least some funds that are tied to the broad market indexes like the S&P 500 as well as funds from different categories like large-cap, mid and small cap, international, and emerging markets. Keeping this in mind, we will suggest two options:

Option 1: Buy-and-Hold portfolio

A buy-and-hold type of portfolio is not necessarily bad for a 40-year old since he/she would have at least 20 years before retirement to smooth out the returns. But the key requirement is that one must follow the discipline and not panic-sell during the big corrections. For this strategy, they would be automatically adding contributions every paycheck, mostly every two weeks or twice a month. This is similar to the dollar-cost-averaging approach. The dollar-cost-average approach can be very helpful for a 20-year time horizon because you would be buying in good times as well as bad, which means you would be buying at high as well as low prices. The biggest advantage of such a portfolio is that this is essentially set-and-forget kind of portfolio and can be left on auto pilot, except maybe annual rebalancing. As a general guideline, the following type of allocation should work on a long-term basis. The below allocations can be suitably adjusted as one grows older.

  • 40% Large-Cap Domestic stock fund
  • 15% Mid- and Small-Cap Domestic stock fund
  • 15% International Developed Markets fund
  • 10% Emerging markets fund
  • 20% Bond and/or Treasuries fund

Option 2 (Better Option): Risk-Hedged Rotational Approach

Not every investor is capable of tolerating large drawdowns that occur from time to time, and they may panic just at the very wrong time. As an alternative to option-1, which has almost no downside protection, one could implement a risk-hedged (or risk-adjusted), rotation-based strategy. This kind of portfolio is designed to capture the majority of the growth during good times and reduce the drawdowns by at least 50% during bad times as well as reduce volatility at the same time. In other words, they provide far less volatility and drawdowns, which results in higher growth. Fortunately, this kind of portfolio can be very easily implemented inside a traditional 401(k) account or IRA accounts.

This strategy would rotate between S&P 500 fund and the treasury/bond funds. When the market is relatively strong and less volatile, the more funds get invested in the stocks (S&P 500). However, when the market starts declining and gets more volatile, more of the funds get switched to Treasuries and/or bonds. In the example below, we are using volatility to adjust allocation to the S&P 500 and Treasuries. Higher the volatility, we will allocate less to stocks and more to Treasuries and so on. Such a portfolio may underperform the broader market slightly during strong bull markets, but protect the capital during major corrections or recessions. There can be many such strategies or variations that could be adopted. The below chart demonstrates how this strategy (within our Marketplace service) has behaved during the recent market correction from Jan. 1, 2020, until July 24, 2020.

[Source: Author/Financially Free Investor]

Author’s Note: A similar strategy (Risk-Adjusted Rotation IRA portfolio) is part of our Marketplace service “High Income DIY Portfolios.”

What volatility measures you use would depend on the individual’s risk tolerance, but for younger folks in their 40s, we would think 10% would be appropriate. The benefits of such a strategy over long periods are clearly visible from the below chart. It provided slightly higher returns than the S&P 500 but without the bumpy ride:

[Source: Author/Financially Free Investor]

Bucket 3: High-Growth Portfolio (20-25% of Assets)

This option is highly desirable at a younger age to provide high growth, although it does come with higher risks, so allocation should be gradually reduced as the investor grows older and approaches retirement.

This bucket will essentially invest in high growth areas of the economy; for example, technology, financials, healthcare, and biotechnology. The problem is that a company that is high-growth today may not be so after two years. So, this kind of portfolio will require at least yearly management.

Every year in January (you could choose any month, but be consistent), we will run a stock screener to filter top 10 growth stocks that meet the following criteria:

  • Market cap > $1 Billion, preferably > $5 Billion
  • Member of S&P 500, DJIA or NASDAQ 100 indexes
  • Revenue growth last 3 or 5 years > 10%
  • EPS growth last 3 or 5 years > 10%
  • Total return last 12 months > 10-15%
  • The projected forward EPS growth for the next 3-5 years > 10%
  • Select no more than three stocks from the same industry.

You also can keep these criteria flexible, depending upon how many companies you get in return. You could then do some due diligence and finalize ten stocks. Buy the 10 stocks in equal proportions at the beginning of the year and keep them for the year. Repeat the selection process every year. Many of the names from the previous year will make it to the subsequent year, but we expect a few of them to drop from one year to next and be replaced by new names. This strategy will require some work on a yearly basis. Most years, this strategy will provide good results unless we are in a bear market. However, we do not have any back-testing results to support this strategy. Further, the downside is that there’s no protection mechanism from market downturns or recession-like situations. If you can tolerate large drawdowns in this bucket, the strategy may be suitable for you. So, please know your situation and risk tolerance. This is definitely a high growth but high-risk portfolio and suited for younger investors who need growth of their capital. One such portfolio within our Marketplace service (chart presented below) demonstrates the resiliency and outperformance over the S&P 500 from the 1st of this year to July 24, 2020.

[Source: Author/Financially Free Investor]

Conclusion

Many of our articles are focused on retirees and near retirees. However, this article is centered around folks who are in their early or mid-40s or nearing 40 but haven’t given much thought about the retirement savings. However, some of the investment approaches outlined above, in fact, could be used by anyone from any age group. In the second part of the article, we presented various strategies to illustrate how one could construct a multi-bucket portfolio for success. Just to be clear, these strategies were presented for demonstration purposes only. Since one size does not fit all, one could adopt some variations of these strategies based on their own individual needs and goals.

There are three major conclusions that one can draw from this discussion.

  1. If you turned 40 already, it’s time to be serious about saving for retirement. You cannot afford to wait any longer. Longer you wait, harder will be your choices to be able to achieve your retirement goals. Compounding can do wonders for your savings, but it needs time.
  2. You need to set your retirement savings goals depending on your current income, spending needs, and other personal factors. While saving on a regular basis is the first essential step, savings alone cannot meet retirement goals. The savings must grow on a consistent basis. In our example of a 25-year-old, saving for 37 years, contributions only accounted for about $200,000, whereas the balance $800,000 came from investment growth over 37 years. With an inflation rate of 2-3%, the average rate of growth of 8-9% is both realistic and achievable.
  3. Importance of multi-faceted investment approach: Investments never move up or down in a straight line. Often, when one strategy zigs, another one will zag. So, it’s helpful to have a multi-faceted investment approach. Not only it helps in diversification, but it also lowers the volatility of the overall portfolio.

Disclosure: I am/we are long ABT, ABBV, JNJ, PFE, NVS, NVO, UNH, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, BAC, PRU, UPS, WMT, WBA, CVS, LOW, AAPL, IBM, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, LMT, LYB, ARCC, AWF, CHI, DNP, EVT, FFC, GOF, HCP, HQH, HTA, IIF, JPC, JPS, JRI, KYN, MAIN, NBB, NLY, NNN, O, OHI, PCI, PDI, PFF, RFI, RNP, STAG, STK, UTF, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. Any stock portfolio or strategy presented here is only for demonstration purposes.


Originally published on Seeking Alpha

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