How to make your nest egg last over 40 years
Reprinted courtesy of MarketWatch.com
Published: Aug. 7, 2013
To read the original article click here
Sometimes I am accused of being too much of a planner, and maybe I should plead guilty.
But if you don’t plan well, how can you know you’ll get where you want or need to go? When we talk about taking money out of your retirement portfolio, this becomes a very important question.
I know people who retire believing that they have enough money to get along just fine — and who then start spending whatever it takes to get what they want or what they think they need. No grand plan, just expedient spending. It’s a nice way to live if you can afford it, but how can you know that?
The biggest risk that retirees face is running out of money before they run out of life. Most of us can’t know how long we’ll live. But it’s possible (and prudent) to organize our finances so that it’s unlikely we will run out of money even if we live to age 100 or beyond.
There’s a simple way to do that, and I’ve helped thousands of investors deal with this question.
To apply this simple method, you need to know three things.
- What is your annual cost of living in your first year of retirement?
- How much income can you count on aside from your investment portfolio? This includes Social Security, pensions, annuities and perhaps rental income.
- What is your retirement portfolio worth on the first day of your retirement?
Let’s look at a simplified example of how these numbers go together.
Assume that your annual cost of living in retirement is $90,000 and that Social Security and pensions will provide $40,000 of that. From these two numbers it’s easy to see that you will want to take out $50,000 from your portfolio.
Now assume that you retire with $1 million in your portfolio, properly diversified among stock and bond funds, and that in addition you have an emergency fund available so you don’t have to make unexpected “raids” on your long-term investments.
With these assumptions, we can get to the nitty-gritty. On this first day of your retirement, you can see that you’ll need to take out $50,000 to get you through the first year. That’s 5% of the portfolio. You figure that you will adjust next year’s withdrawal to reflect actual inflation, and that seems pretty reasonable.
But how reasonable is it? How safe is it? That’s where a table of historical results may help. The returns that were used to generate this table are from the big table referred to in my column “Fine-tuning retirement portfolio allocations.”
Right away, as you look down the columns you will see that the money ran out at various times, depending on your choice of an equity-bonds allocation. Unless you had at least 40% of your money in stocks, you would have run out before 2000.
Second, you will see that, in order to make it through 2012 with enough left in your portfolio to support some years of future inflation-adjusted withdrawals, you had to have at least 60% in stocks. Even though you would have ended 2012 with nearly $2 million, this 60% equity portfolio could not last very much longer because of the large, ever-increasing withdrawals.
You could overcome that problem by investing more heavily in stocks, but that entails more risk than is comfortable for many retirees. Many people don’t want to have even half their investments in stock funds.
There are three other ways to address this problem. One is to save more money when you’re working. A second is to keep working longer, giving you more years of saving and fewer years of living from your portfolio. The third is to plan on spending less in retirement — in other words to withdraw less from your portfolio.
Take a look at Table 1. It shows what would have happened starting in 1970 with all the same assumptions except that you started by taking out $40,000 in 1970, a withdrawal rate of 4% instead of 5%.
If you look at that table you will see that all you needed was 30% of your portfolio in stocks in order to have ample money to get through 43 years of retirement. That is much less risky, and hence more comfortable, than some of the options I discussed above. However, this table shows that, even with this modest withdrawal rate, it was still necessary to hold some stocks in your portfolio.
You can also look at Table 3, which shows what would have happened to retirees who started out taking 6% of their portfolios in 1970. This of course gave those retirees more money to spend in their early retirement years.
However, you will see that the only way to make it through 2012 was to have the entire portfolio invested in stocks — way too risky for retirees.
So why do I even bother to invite you to look at this table? Because far too many retirees think they can live on inflation-adjusted withdrawals of 6% or more. I have read statistics that more than 30% of retiree households take out 7% or more. That places them at severe risk of running out of money before they run out of life.
If you want to dig deeper into this topic, join me for an extended podcast on the important lessons of these tables and how to use them whether you’re planning for retirement or trying to manage it.
Next week I’ll discuss what I regard as the ultimate distribution strategy, an approach that I consider the greatest luxury a retiree can have.
Richard Buck contributed to this article.
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