Levels vs. Flows

Retirement planning is a modern problem

Citizens have been conditioned to think of money in terms of "flows" for their whole life. "Flows" refers to a rate of change. For example, when discussing income, it is important to understand what the rate is. People think $20 an hour or $50,000 a year. The number doesn't make sense unless you include a time component. Flows show up all the time in economic indicators as well as investing. When an investor said he made 20% on an investment, would you feel the same if it took 20 years versus 1 month? Clearly, time plays a very important role in some numbers.

"Levels" (or "stocks", RewardBus uses "levels" since "stocks" can be confusing when considering securities) refer to the amount of something at a various point in time. In other words, what is the state of the union TODAY? How much money is in your checking account? How much do you owe on your house? What would your car sell for today?

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For many, the relationship between levels and flows is very confusing. Income is a flow but wealth is a level. Retirement planning is many Americans' first encounter with the concept of levels (even purchasing a house is often thought of as how much the mortgage payment is (flow)). How can you convert a nest egg into income? How can you convert income into a nest egg?

Retirement planning is a long, arduous process. It involves taking a flow (how much are you saving a month?) and turning it into a level (how much do I own today?). Then, when you retire, you need to take that nest egg and turn it back into a flow. The first step is to assess what you need for retirement.

How Much Do You Need?

Many retirement planners espouse the "4% safe withdrawal rate"*. This means that if you expect to need money for the next 30 years, pulling out 4% a year is a relatively safe strategy. Using the 4% safe withdrawal rate, you take the income you expect and multiply it by 25. If you are looking to spend $40,000/year in retirement, you would then need $1,000,000 in a nest egg to maintain the nest egg for 30 years with 95% certainty.

The two major other considerations in the rule are supplemental income and length of retirement. Length of retirement may be difficult to predict, since you are trying to predict when you die (a very exciting endeavor) but rough expectations are fine. If you are a woman retiring at age 45 in relatively good health, it is safe to assume you will live 38 years. Longer if you are a non-smoker. Since you need 38 years instead of 30 years, you may consider having a lower withdrawal rate (something like 3.5%).

Supplemental income refers to all the various methods of slowing your burn (burn refers to how quickly you are drawing down your money). The most common form of supplemental income is social security. Many others find second careers or freelancing. For example, if you see a large downturn in the markets in your first 5 years of retirement, nothing is preventing you from finding a part-time job to help supplement your income.

Nothing is final. Take your time and determine what you need in retirement and your level of risk tolerance.


*94.8% of the 30-year spans since 1871 have been able to pull out 4% of the nest egg, adjusted for inflation, every year without fully depleting the nest egg