How you’re being misled by retirement-saving advice
Reprinted courtesy of MarketWatch.com.
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As baby boomers approach and reach retirement age, there’s a lot of anxiety regarding whether or not they will have enough financial resources.
Many somewhat simplistic formulas have been applied to this question, each of which is at least somewhat useful — but each falls far short of doing the whole job.
Example: You can afford to retire when you have investment assets equal to (fill in the blank) times your current cost of living. This is good because it focuses on replacing a pre-retirement cost of living. But it doesn’t take other assets, obligations, income and uncertainties into consideration.
There’s really no way to get a good answer to the question without rolling up your sleeves and asking yourself some probing questions. Questions like these:
If I could continue my current income for the rest of my life, adjusted for inflation, would that be enough to meet all my anticipated needs in retirement?
If I retire now, how many years do I need my investments to support me?
Is it OK with me to use up all my investments by the time of my death, or do I want to provide for others in my will?
Am I really able and willing to scale back my retirement lifestyle, if necessary, should my investment returns fall short of my expectations?
Alternatively, can I reasonably count on being able to work part-time, if necessary, to make ends meet?
How anxious will I be if I plan to have my retirement income vary from year to year depending on how well my investments perform?
That’s a lot to think about.
Over the years I have found that it’s helpful for people to study some tables of numbers that show hypothetical investment returns and withdrawal rates.
I suggest you use these tables along with the accompanying discussion, to start figuring out for yourself whether or not you have enough money to retire.
Let’s start with one of the tables to see what we can learn from them. The second table, Table 2, is based on several important assumptions: It’s 1970 and you have just retired with $1 million in your portfolio. You have properly diversified your portfolio to include much more than just the most popular asset classes. You will withdraw $50,000 in your first year of retirement (a 5% withdrawal rate, in other words) and you will increase that amount every year based on actual inflation.
The table has 12 columns of annual portfolio values. Since each year’s distribution is “fixed” by the assumption of $50,000 plus inflation, the only reason the columns have different numbers is that the portfolios are invested differently. On the left is a portfolio entirely in bond funds. On the right is one that’s entirely in the Standard & Poor’s 500 Index SPX, -0.24% The portfolios in between are widely diversified equity funds, with varying percentages of stock funds and bond funds.
When you look at the table you can instantly see that the yearly portfolio values dwindle and disappear in seven of the 12 columns — a majority. The blank white spaces indicate years in which our hypothetical investor ran out of money because the portfolio returns were insufficient to keep up with constantly rising withdrawals.
So here’s one obvious conclusion: A retirement portfolio based on these assumptions needed at least 60% in equities to keep supporting the retiree through 2014. In 2014, the “fixed” distribution was $310,266, only about one-sixth of value of the portfolio at the end of that year. This withdrawal rate couldn’t last very many more years, which means that particular portfolio was approaching extinction.
To support a reasonable expectation of continuing much longer, the portfolio would need to be invested at least 70% in equity funds. And yet, the level of risk in such a portfolio is greater than most retirees can or should take.
I realize that 45 years is more than the life expectancy of most retirees. But if you expect a portfolio to continue to support a surviving spouse or to end up with enough to make significant gifts, some extra margin is necessary.
So it’s reasonable to conclude that this plan — 5% withdrawals increased every year for inflation — is less than ideal for most retirees.
Fortunately, there’s a better alternative. You’ll find the evidence for it In Table 1. The numbers here are based on the same assumptions as the previous table — with one crucial exception: This time we assume the 1970 retiree could get by with an initial withdrawal of $40,000 instead of $50,000. In other words, this investor had saved enough to get along with an initial withdrawal rate of 4%.
As you look at this table you can see that only three of the 12 portfolios ran out of money. Those, as you might expect, were the ones that were invested most conservatively.
By the end of 2014, the 30% equity column was withering and couldn’t be expected to last many more years. But all the columns with 40% or more in equities were in solid shape to keep going with this withdrawal plan.
Tables 1 and 2 contain a clear lesson: If you save enough money before retirement so you can meet your needs with withdrawals of 4% instead of 5%, you can invest more conservatively, and without much risk of running out of money. (Obviously the next 45 years won’t be the same as these, but I don’t have any reason to think that their general patterns will be radically different.)
So the original question remains: Do you have enough to retire? Obviously that depends on whether you want to retire with “just enough” or with an extra measure of assets so you’ll face less risk and less stress.
If you retire with only enough, you face several major risks. One is that, like many retirees, you will want or need to withdraw more than is prudent. Another is that you will invest your money so conservatively that your returns will struggle to keep up with inflation.
On the other hand, you run the risk of investing too aggressively, trying to make up for inadequate savings; if you do that, you may have an awful time getting through normal market declines.
This is a tradeoff, and the choice is entirely up to you. My recommendation won’t surprise you: If you can, save more than “just enough” before you retire.
These tables contain important lessons that can benefit investors. I have discussed them in my podcast, “Ten life-changing lessons regarding retirement distributions.“
We aren’t quite finished looking at withdrawal strategies. There’s another way you can cut this cake, especially if you have saved more than “just enough.” We’ll take that up next week.
Richard Buck contributed to this article.