Figure out your Minimum Rate of Return (MRR)

You have to know your MRR to design a realistic portfolio

You need to know 3 things. How much money you have saved as of today, how much you'll need when your job ends, and what rate of growth it will take to get from point A to point B. Sounds simple enough, right? Well, not exactly. Here's how to do it.

1. Tally your current nest egg.

Brokerage accounts, 401k accounts, IRAs and other tax deferred accounts, savings accounts, CDs, and the like. The important thing is to only include money that you have earmarked for saving, not spending at some date in the future.

2. Make a conservative estimate of how much you will be adding to these accounts in the future. Ignore raises, inflation, taxes etc. We're interested in today's dollars. We're assuming that your future raises and increasing taxes and inflation will all "come out in the wash" so to speak.

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3. Take the sum of all your expected future contributions and add them to your current nest egg balance. This is what you'll have, in today's dollars, when you stop working and contributing to savings. As the years go by, you'll make adjustments to these numbers to reflect what's actually happening. 

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4. Look at your total monthly living expenses as of today, and ask yourself this question: When my paycheck stops, and the kids are grown, will I need to spend more than my current monthly expenses, less, or about the same?

Again, forget about variables like raises, inflation and taxes for now because they're unpredictable. Just go with today's dollars. This could be the hardest part of figuring out your MRR, so take your time and think carefully about your estimate. 

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5. Now take the sum of your current nest egg, plus all your expected future contributions, and come up with an estimate of your retirement nest egg. The worksheet below shows an example of what this looks like.

6. Now you have a basis for computing your MRR. Your future nest egg will not get you to your objective, so we have to add a little growth to the mix. This is where those retirement calculators we discussed come in handy.

Which online calculators are the best?

You plug in the numbers from your worksheet, and make some estimates about what you can reasonably expect for a growth rate on your investments. I suggest you start with a conservative rate - say 7% or 8% annual return. The calculator will spit out a final nest egg, and that will be our next basis for moving forward.

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7. The next step is for you to do a little dreaming about what you want your lifestyle to look like when you retire. At 35 years old, your lifestyle and your monthly nut are probably a little tight. You want to be able to live a little when you're 65 or whatever age you choose to stop working, so make 3 estimates. 

What would be the least amount of money you could live on, the realistic amount, and the comfortable amount? Today your monthly nut is $3,500 (just to pick a number). You could continue to live on that in retirement, but that wouldn't be ideal.

It would be reasonable for you to increase your nut by 50% so you can do some travelling, dine out more often, visit the grand kids regularly, and perhaps buy that cottage on the lake you've always wanted.

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And if you want to dream a little bigger, why not go for double or even triple your lifestyle expenses? It can be done. Others have done it. But it would require you to take big risks with your investments. It's a matter of personal choice.

8. Now you have your current monthly nut, your future monthly nut, and your estimated annual savings rate. Next is figuring out how big your future nest egg has to be in order to generate enough monthly income to cover your future nut.

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Will $500k be enough? $1 million? or will it take $2 million or more? To answer this we need to know all of your sources of income in the future - Social Security, pensions, annuities, rents and royalties, and so on. These are cash flow items, not capital appreciation items.

Making realistic assumptions

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To be conservative and realistic, assume that you'll get a ~6.5% return on your final nest egg. Working backwards from there, you can calculate how big your nest egg has to be in order to generate enough monthly cash flow to support your lifestyle.

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Let's assume for argument's sake that you'll need a nest egg of $2 million to maintain your current lifestyle. You can calculate your MRR by using an online calculator and plugging in your final nest egg, beginning nest egg, and number of years to get there. 

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Let's say the calculator spits out a 10% annual rate of return to get you there. From this you deduct your savings rate and arrive at 7%. This is your MRR. Your nest egg has to grow at a 7% annual rate in order for you to end up with enough money to fund your future lifestyle.

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But what if your MRR works out to be much higher than 7%? You have two choices...

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You can either raise the bridge or lower the water

You can raise the bridge by finding ways to grow your nest egg faster, or you can lower the water by reducing your lifestyle expectations. There are no other realistic options.

You could save more by tightening your current budget, or you could boost your returns by taking more risk with your investments. It's up to you. This is where your portfolio design becomes critical. 

Your asset allocation can get you there

I say it can get you there but maybe it can't. If the gap is too wide, your asset allocation alone won't fix it. But you should do everything you possibly can to squeeze as much return as you can from your portfolio, without going beyond your true risk preference.

It would make little sense, for instance, for a risk-averse investor to take an aggressive posture in the market in order to boost returns. At the first sign of trouble, this investor will likely make mistakes that will undo everything gained when times were good.

Your security selections are important but not that important

It's very important to be careful about the securities you bring into your portfolio, but this pales in comparison to your asset allocation decisions. Studies show that asset allocation accounts for as much as 90% of portfolio returns. (Security selection contributes less than zero in most cases.)