Wednesday, October 15, 2014 |
Joe Alfonso, GoLocalPDX Contributor
Imagine that you‘ve reached the end of a long working career. The house is paid off, the kids have finished college and your retirement savings have grown to be worth $1M as a result of your diligent saving and investing over many years. Now is the time to enjoy the fruits of your labor, call your career quits and embark on a new life in retirement free to spend time with your family and do all the things you’ve been putting off doing for so long.
You’ve looked at your ongoing spending needs and concluded that you can live your chosen lifestyle on around $50,000 a year. Putting aside Social Security, you figure that as long as your portfolio returns at least 5% per year on average after inflation you will be able to support your spending and even increase it over time to keep pace with rising living costs. Given that over the last 40 years a 60/40 stock/bond portfolio has earned about 7% per year after inflation, you feel pretty confident as you set sail into your golden years that running out of money is not something you will need to worry about for the rest of your life.
Unfortunately, this simple back of the envelope analysis is flawed and basing your retirement spending on it could cause you to run out money well before you run out of life. Why is this so?
Twenty years ago this month, a financial planner named William Bengen published an article titled “Determining Withdrawal Rates Using Historical Data”. Bengen looked at annual historical portfolio returns over rolling periods of up to 50 years in order to see just how much a retiree could safely begin withdrawing from a portfolio at the start of retirement, increasing that amount throughout retirement for inflation, and not run out of money during his or her lifetime. Bengen assumed a simple 50/50 portfolio equally composed of intermediate term US bonds and US common stocks.
Based on the annual sequence of returns experienced by the hypothetical retirees in this study, Bengen found that the highest initial withdrawal rate (as a percentage of total portfolio value) during the historical period for the worst case retiree, who began retirement in 1966, was 4%. In other words, no retiree during the period studied (1926-1976), regardless of when they started retirement, would have run out of money in less than 30 years as long as the amount they withdrew from their portfolio in the first year of retirement was 4% or less of total portfolio value; in each subsequent year, any of these retirees could have increased their initial year’s withdrawal amount by inflation and still have had money left over after 30 years of withdrawals.
Bengen’s research was groundbreaking and brought to light the fact that “sequence of returns risk” is a key challenge to achieving a successful retirement – success being measured as not running out of money prematurely. Bengen showed that the order in which annual returns occur is more important than the annualized rate of return over the same period.
Retirees who begin retirement when returns are low and portfolio value is falling spend down their portfolios faster than retirees who retire when returns are high and portfolios are growing. The unlucky retirees run a higher risk of exhausting their assets within their lifetime while the lucky ones are more likely to leave an inheritance for their heirs. This is true even if returns recover in later years for the unlucky retirees or drop for the lucky retirees: withdrawals made in the first years of retirement from a portfolio that is underperforming increase the risk of failure; well-performing portfolios can sustain higher initial withdrawal rates even if performance drops off in later years.
Subsequent research, by Bengen himself and others, showed that more diversified portfolios can support higher initial withdrawal rates. Still other research showed that retirees who forgo inflation adjustments after poor return years can safely begin retirement at a higher withdrawal rate in exchange for these later mid-course corrections. Recently, some researchers have begun questioning if even a 4% initial withdrawal rate is safe given their belief that future stock returns will be lower than the historical averages and given current historically low bond yields.
All of the research into sequence of returns risk points out the danger inherent in generating retirement income by withdrawing a constant amount from a volatile portfolio. While relying on portfolio income is unavoidable given the demise of pensions, having a carefully thought out withdrawal policy that reflects the best research in this area is crucial. It is also important to lessen reliance on portfolio income through actions such as careful budgeting, maximizing Social Security benefits, and other related strategies.
Managing withdrawals from your portfolio in retirement is quite a different challenge than investing for retirement itself. Approaching this challenge correctly will help you enjoy your retirement with more confidence in your ability to maintain the lifestyle you desire for as long as you live.
A version of this article originally appeared in the Business Section of GoLocalPDX