GOT ENOUGH FOR RETIREMENT ?
How To Approach The Situation
There is no way anyone can give you an answer to the question - "Do I have enough $$ to retire?". The only time you can answer a certain "yes" is when a portfolio is so large that it can buy insurance products to cover off all the risk and uncertainties listed below ... and when the person actually WILL buy the products instead of other riskier investments. That would be a very large nest-egg indeed, and the person with that much saved will probably NOT spend it on insurance products.
Neither you nor any advisor can know the answer because the future is
unknown. So don't shop around for an advisor who will tell you what you want to hear. It is a guess at best. All answers will depend on:
- assumptions that will change over time,
- assumptions about normality that don't reflect real-life's
- small probabilities of extreme outcomes you must consider.
You can try to estimate "How Much I Will Need" and later "Do I Have Enough" by working with today's dollars and adding inflation into the calculation later.
- What do you spend now? Don't include yearly savings or mortgage payments. Don't include today's income taxes because the taxes paid in retirement can be radically different.
- Estimate what your spending will be just before retirement (in today's dollars). Do you expect to move up the corporate ladder and earn more (and spend more) or do you expect your cost of living to increase only with inflation?
- Decide whether your spending in retirement will be different than your spending while working. If you plan to travel or have other expensive recreation costs your spending will increase. If your current spending includes many work-required items like commuting costs, then your spending will decrease. Ignore the rules-of-thumb stating that you will spend (eg) 70% of your pre-retirement income. Your spending will be relative to your pre-retirement spending, not its income.
- Reduce that budget by the amounts that will be funded by any pension, CPP and OAS. Ignore GIS because any readers here should presume it will be clawed back. Include the investment income earned by that $1M Aunt Martha leaves you.
- That leaves you with $ spending requirements that must be funded by your personal savings. Divide that by the Safe Withdrawal Rate percentage to calculate the nest-egg required. There is a discussion below on SWRs.
- Given that portfolio's size (still in today's dollars), consider the taxes it will generate and revise your retirement spending $$ accordingly. Use this spending spreadsheet.
Don't think that your life will now be mapped out with any certainty. Please read this very realpolitik article why even the most successful plans fail during retirement ---- and no it is not because the markets were poor.
How Much To Save
The quick and easy answer for a young person is between 15% to 20% of your wages every year. This is the number that will probably leave you with least regret if you don't get lucky in life. If you do get lucky then you can retire early and thank your lucky stars. The media may tell you that only 10% or 15% is needed. But that number is probably set low so you don't freak out completely - causing you to save nothing. The savings rate used by governments and pension plans all around the world validate the higher 15% to 20% requirement.
If you are asking "Am I saving enough?" it probably means you COULD actually save more. Given life's uncertainties, why limit your savings? Be the Millionaire Next Door. There is no real down-side to saving more. You may reach your goals earlier than expected, giving you the choice to retire early, etc. The graph below of historical outcomes shows the huge variability depending on your luck to be born in different generations. You cannot plan away this variability. You can only save more than you think is enough.
Many people believe that it is OK to not save much while young and middle aged because they will be able to sock away piles of cash after the mortgage is paid off, and after the kids have left home and their tuition fees paid. A 2015 American paper found that savings rates do NOT increase. For a year-by-year projection of spending vs savings that will result in a portfolio large enough to fund retirement spending use this saving spreadsheet.
Income Tax Rates
Taxes you pay will have a huge
impact on the cash you can spend. Don't mistakenly use the 'marginal'
tax rates commonly quoted for financial decisions. Calculate your
anticipated 'average' rate using the bottom box of this tax rate spreadsheet. Beware of Canadian Minimum Tax.
Canadian governments have undertaken to adjust with inflation, the income limits of our tax brackets. This makes planning easy because income of equal purchasing power, at different points in time, can be assumed taxed at the same tax rate.
Be clear in your mind whether the $$ withdrawals you are calculating include the cash needed to pay taxes, or whether taxes are being deducted from the rate of return percentage used to calculate the changing size of the retirement portfolio. I.e. are the taxes considered paid by the person, or by the portfolio?
Don't calculate tax as a percent of your anticipated spending. Tax is triggered by income from government benefits, pension plan payments, portfolio profits of taxable accounts, and withdrawals from RRSPs. That taxable amount will be quite different from the $$ you spend. If you plan on dying broke, you will spend more than your portfolio returns - using untaxed capital. Otherwise, you will spend at lot less than your taxable income, especially at the start of retirement.
Government Support For The Elderly
Government support for the elderly includes GIS, OAS and CPP. These benefits make a huge difference for lower-income earners. In year 2000 income from retirement programs made up 46% of the average elderly Canadian family's gross income. The clawback of these benefits from increasing income creates a large difference in outcomes depending on whether you saved in an RRSP (draws taxed) or a TFSA (not).
The image above shows the Canadian marginal tax brackets on the left. In the middle is the income you can expect in retirement from GIS and OAS and CPP. GIS benefits are not taxed. OAS benefits are taxed, but not considered for GIS clawback. 84.5% of the published GIS maximum benefit is clawed back at 50% of added income. 15.5% of the benefit is clawed back by an additional 25% ... creating a 97.5% effective tax rate when the Personal Examption is exhausted.
You frequently still find claims that GIS is clawed back at 50%, without any mention of the additonal 25%. This is because things changed in the 2011 budget. A new section of the OAS Act for "Additional Amounts" added benefits that get clawed back after $2,000 income at an additional 25% rate. These top-up amounts are created by budgets and subject to change. After the $600 added in the 2011 budget, another $947.04 was added in 2016. All these numbers increase in with inflation. Until a subsequent budget (after 2017) changes things again, the existing 15.5% / 84.5% split will continue.
These inflation-adjusting benefits are a relatively recent invention. The chart above shows how they grew to their current values. How to treat them in your long-term planning is a personal decision. There is a lot of worry that their costs will not be supportable when the Baby Boomer bulge hits retirement. The rest of this page assumes only that government benefits and programs will offset your higher healthcare costs for drugs, physio, eyeglasses, hearing-aids, etc. It is better to err on the downside. It removes two unknowns from the model.
Inflation is a variable input in both the saving spreadsheet and the spending spreadsheet. Unlike all other public calculators, the inflation adjustment is applied only to living expenses, not including taxes paid. Long-term history indicates 2.5% is reasonable, but real-life can vary drastically.
Most commentary on investment profits quotes returns 'after inflation'. This implies that stock markets will have higher returns in periods of high inflation and that you need not worry about inflation. But history shows there is NO correlation between returns and inflation. Look at the graph on Sheet 17. Yes, over time businesses correct their pricing to compensate for inflation, but that correction takes time to implement. Keep your assumptions of investment returns separate from inflation assumptions.
Gold-plated pensions are indexed to inflation, but few people have those. Annuities that you buy from trust companies come in a version that increases with inflation, but they cost a lot more (payments about a third lower). They also have clauses limiting the amount of the yearly inflation increase to (say) 6%. Most people do not feel the trade-off is worth it.
Just because your annuity payments are flat does not mean you cannot deal effectively with inflation's erosion. You simply do not spend all the income of early years. You set aside and invest a portion. You gradually build up a portfolio of value that will later be drawn down to cover your growing cost of living. This spreadsheet converts a flat payment to an amount you can spend that grows with inflation.
The flat annuity benefits (vs your increasing cost of living) works well when you plan on an active (and expensive) lifestyle when newly retired, and a more sedate (and cheap) lifestyle in later years. You buy the amount of an annuity that will cover your inflated cost of living at age (say) 85. That annuity will pay benefits at the start that exceed your basic cost of living. So you use the excess for extras like travel, while you are healthy.
Inflation experienced by retired people differs from that experienced by the general public or measured by the CPI. Their spending is weighted more to the food, energy and housing factors. This means that benefits linked to the CPI may not really offset inflation's effects (e.g. pensions, real-return bonds, CPP, adjustments to tax rates, etc).
Owning your own home is a great hedge against inflation. The value of the rent saved will grow with inflation and the principal value of the home will also grow with inflation. Even better if you have a rental suite to cover the increasing cost of your other bills.
It is common to read that bonds do not generate an inflation adjusted income. It is true that the principal to be recovered at maturity does not increase with inflation (except for RealReturn bonds). But the income you receive each year does include compensation for inflation. Your expectation of inflation is built into their yield. When you want a portfolio of bonds to grow with inflation you must reinvest that inflation portion of your interest each year.
Long-Term Care Costs
Medical care for the last few years of your life can wipe out your savings. It cannot be ignored. There are five ways to deal with it.
- You can depend on family caregivers and/or friends to provide the care for free. The first to die of a couple can rely on the healthy spouse, but the second to die may have no one.
can set aside the value of your home (with no mortgage) from your other
retirement calculations - understanding that its eventual sale will fund
the nursing home costs.
- If you maintain the
inflation-adjusted value of your investment portfolio, it will be available to run
down over that last few years of your life in a nursing home.
can buy long-term care insurance, but this is very, very expensive. The industry will tell you to buy it while you are young and healthy because rates will be lower. But they are allowed to periodically raise rates, and paying for more years can be more costly than paying higher premiums for fewer years.
- You can generate the cash to pay for long-term-care insurance by taking out a reverse-mortgage on your home. This is fine if you can manage to die at home. The main problem is when you need to move away from the home before you die because of poor health. At that point you no longer have any equity in your home so you would need long-term-care insurance in addition.
With a couple, the first to get sick can impose unintentional emotional blackmail on the healthy spouse. All the couple's assets may get spent, leaving none to support the survivor, who must pay for institutional care at the end of her life. It is unknown at the time of the first spouse's illness whether the survivor will need ANY additional care. She may drop dead on the spot after being perfectly healthy. This prompts people to spend all the money they have on the first to get ill. The probabilities discussed below show that women (who presumably care for their husbands' first for free) have a higher probability of needing professional care.
If the survivor is a second-wife and the assets get left in a testamentary trust there is also a problem. Normally income earned by the trust goes to the second-wife during her life and the capital is distributed to the kids on her death. While the income from the trust may pay for normal living expenses, it most probably won't be sufficient for long-term-care costs. Even if the kids, from the first marriage who would receive the eventual principal, want to help out, they may not be able legally to touch the principal dollars in the trust.
Statistics on projected needs for care are hard to come by. Reverse engineering LTC premiums leads to the conclusion that insurance companies presume an average 5 years of benefits. But that would apply only to the subset of the population that buys insurance. A 2005 US study concluded that only 20% of people would need care for more than 5 years. Another 2014 study was also optimistic and found a high probability of nursing home stays, but for only short durations.
Working from a 2016 database of American experience, Crook and Sutedja modeled probabilities. They find that 85% of healthy couples at the age of 65, will have at least one partner needing some form of care before passing away. This includes home care, assisted living, and nursing homes. The average age of first use is 80 years. But that overstates the risk because it includes use for even one day only. There is only a 18% chance of one spouse needing care longer than 5 years. Individually, needing care for 5 years is only a 3% probable for men and 11% for women.
It is the cost of nursing home care that will do most damage to any budget. Although there is a 78% probability of individuals needing this care, the median duration is just 9 months. There is a 32% probability of needing more than 1 year's care, but only an 8% probability of needing more than 3 years. Approximately 77% of people that go into a nursing home return to the community.
It is not just big-ticket LTC and end of life care that drain finances. Even though Canada has 'free' health care, a 2016 Ontario HOOP analysis found significant out of pocket medical expenses at later ages. For singles with a medical issue, medical spending as a percent of total expenditures, rises from 9% at age 40-44, to 20% when older than 80. Of those older than 85 not in an institution, still 25% of women amd 15% of men have a severe diability. The percent of the population over 85 living in nursing homes is 14% for women and 9% for men.
Investment returns are a huge unknown. The small returns from safe assets are not sufficient for most people to fund their retirement, so risky assets must be owned. Their variability of returns, and sequence of returns, will greatly impact the portfolio's sustainability. In retirement, sequence of return risk plays out like 'dollar-cost-averaging' in reverse. Withdrawals after a market decline will remove a greater portion of the portfolio, than the same dollar amount drawn at market highs. Computer modeling with MonteCarlo or bootstrap simulations, have all shown that poor returns at the start of retirement destroy its sustainability. Returning to work might be the best decision if this is your reality. So do not burn your bridges behind you when you retire.
There are ways to mitigate sequence-of-returns risk in retirement.
- The Canadian government will help out in years of poor returns when investments are held in taxable accounts. The capital losses can be claimed against prior year's capital gains, and their taxes recovered. That cheque may be big enough to fund a year's expenses.
- You can maintain a near-cash account from which to draw your living expenses without triggering sequence-of-returns risk. You top up this fund after years of high stock market returns, and draw it down in years of losses.
- Everyone agrees that reducing your spending in years of poor return - flexible draws - adds safety. You are guaranteed to never run out of money if your $ withdrawals vary with the changing value of your assets (eg. at a set %). You trade off the certainty of some available cash against the pain of a variable standard of living. The riskiness of your portfolio determines both.
- Dividends from steady stocks are one way to reduce portfolio risk. See the second sheet of this Dividend Vs Growth Portfolio spreadsheet. A high dividend portfolio will show less price volatility. That lower volatility will reduce sequence-of-returns risk.
- Changing your Asset Allocation percentages as you age may help. Academics are reporting very contradictory conclusions, so read the section below on AA. Some show good results from spending debt assets first, or taking cash from the best performing asset class (Spitzer,Singh paper). This allows equities time to recover from any poor returns soon after retirement. This is what the 'buckets' approach does. It results in an increasing allocation to equity as you age - the exact opposite of 'age in bonds %' advice. Other academics have found the opposite.
Historical average returns don't predict your future returns and especially don't predict your sequence of returns. There are two schools of thought - the random walk school and the reverting-to-the-mean school. Most retirement planning advice seems to come from the reverting-to-the-mean school, where good returns are followed by bad, where income smoothing will even out market peaks and troughs, where the future can be predicted by today's Price/Earnings multiple, Dividend Yield and Interest Rates. Pfau has devised a simple math model that essentially predicts rates of return and determines the appropriate withdrawal rate, all in one fell swoop. Use the Pfau's spreadsheet at your own risk.
Don't be fooled by market cycles into thinking you can retire early, or spend more in retirement just because your past returns have been exceptional. Most of the dollars spent in retirement come from profits earned after retirement, and good markets are followed by poor ones. Unless you crystallize your good fortune by buying insurance, you should expect reversals. A 2012 paper (A Case of Myopic Extrapolation) shows that purchases of annuities vary widely depending on very recent stock market returns that the naive investor presumes will continue. Good stock returns result in low sales, and vice versa. This has the irreversible effect of crystallizing stock losses.
This is the risk of running out of money because you live longer than planned. You may be the 1% that lives to 102. You can find many longevity calculators on the web. Look up your expected remaining life span. Compare your longevity to the longevity of your savings, using the 2nd tab of the spending spreadsheet called "Longevity of My Savings". There are ways to deal with longevity risk.
you are lucky enough to have a defined benefit pension plan that is
sufficient to cover your necessary costs, you have no worries. Although few DB pensions still exist, those that do are usually inflation adjusting.
- The Canadian Pension Plan (CPP) and Old Age Security (OAS) benefits continue until death and are inflation adjusting. Most people will require more income than they provide.
- Owning your own home provides you with free rent until you die. Even better if there is a rental suite with income to cover your property taxes.
- Otherwise, you must buy longevity insurance. The
most effective way is to buy an annuity. You get the most
benefit by waiting to make the purchase until you are over 60 when your age-cohort starts dying. The price of annuities is better for couples than for single people. See the separate page on annuities
can get a reverse mortgage on your home. This too, assigns your
longevity risk to another party. But in the process, you destroy your
home equity and reduce the eventual sale's proceeds that can be used to
fund long term care at the end.
- You can presume (for the purposes of deciding how much to spend) a lifespan that is long in the extreme - say 120. The point is that you cannot use any kind of population average. Using this assumption will result in much lower spending while alive, and a larger legacy portfolio for many.
- You can adjust your yearly spending according to a new calculation each year that assumes a lifespan half way between the your age-cohort's average and your extreme possibility. The surviving population's lifespan lengthens with age, so this calculation corrects for longevity, but it may result in 'allowed' withdrawals late in life that are very small.
or Maintain Wealth?
This is the biggest decision to make. 'Die broke' allows you to spend
more, but leaves you more exposed to the risk that you outlive your
savings. You certainly won't have a pot of money left for long-term medical care. Investment returns may be lower than expected, tax rates and
inflation may be higher and your lifespan may be longer than predicted.
What, exactly, do you plan to do then?
Milesvky (paper) has found that 'outliving your expected death' ranks with 'poor initial market returns' as by far the biggest risks facing retirees. Common sense says you should never PLAN to die broke. It may turn out that you Do, but it should only be because the gods have conspired against you. You can see that the difference in Safe Withdrawal Rate between the two choices is very small on the spending spreadsheet.
Planning to maintain your wealth is a far less risky strategy because it removes the lifespan risk. At retirement you spend only what is left from your
investment returns after taxes are paid and after the amount of inflation
in retained and reinvested.
- You may leave a legacy to your kids or charity.
- You can self-insure against unknown investment returns.
- You maintain the ability to make large purchases like real-estate.
- You can self-insure against unknown health costs.
- As you get older, replacing inflation becomes less critical, and eventually dipping into the principal is also safe.
Asset allocation depends on how rich you are, compared to your spending. There is a curious opposition between the risks each person can AFFORD to take and what he NEEDS to take. Advisors seem to base asset allocation recommendations on the NEEDS criteria. They choose to tell the rich to satisfice - be content with low but safe returns because they don't need the extra income to finance their lifestyle. Advisors choose to tell the poor to assume more market risk, ignoring the obvious outcome of risk that is beyond their tolerance. (They will sell after market crashes).
In contrast the rich can AFFORD to take more risks because they would still have 'enough' even after losing half their wealth. They can invest in 100% equities and live off the 2% dividends. The poor cannot AFFORD to take risks because there is no room for losses. It is a bad idea to opt for the 'hail-Mary-pass' hope to salvage the plan. Highly variable, risky returns can easily make a bad situation much, much worse.
Asset allocations during retirement also depend on the chosen draw-down strategy. A fixed $draw will create large sequence of return risk effects. But flexible spending, that chooses a high-priced treat only after a year of high returns, will face little sequence of return effects. The portfolio does not need the low-return, but safe, Treasury bonds because normal spending is kept low.
Age In Bonds : There is widely repeated advice that a retired person's portfolio allocation in common stocks should equal 100 (or 110) minus his age. The percentage allocation in debt should equal his age. It increases over time. This advice dates back to an era when men retired at 65 and died 10 years later. The unstated presumption is a die-broke situation where living expenses come from maturing or selling bonds, and so their value must be predictable within short time-frames.
Retirement now stretches out 40 years. It is much more important that portfolios grow to compensate for inflation and longevity risk. When you plan to live off a portfolio's income instead of its principal, the certainty of liquidation values becomes less important.
Glidepath : Mutual funds and ETFs that are classified as Target-Date-Funds provide investors with a portfolio that is managed to change its asset allocation as it approaches a stated retirement date. Much like the Age-In-Bonds strategy they increase the proportion allocated to bonds as the retirement date approaches. This strategy is consistent with their investors' preference for downside protection rather than upside potential as they near retirement. It is agreed by all that in early retirement a few years of poor returns have a very large destructive force on the portfolio. This is the sequence of return risk. The debated issue is how to deal with that reality - how to make the risk/return trade-off.
Increasing Risk : Some research on target-date-funds shows negative benefits from lowering your allocation to equities in the accumulation phase before retirement. See the Saving Money page. As retirement approaches the portfolio is at its biggest size. The returns it earns then have the largest impact on its size. Choosing to own low-return bonds when the portfolio is large means much growth is missed. That cost can be bigger than the sequence of returns effect.
Once in retirement, Spitzer shows that you have the best chance of not outliving your wealth if you deplete your debt first. In other words, during retirement you increase your common stock percentage over time. This has the same effect as the 'buckets' strategy for withdrawals.
Some experts are advising a middle ground. They say that portfolio risks should be high when young, that risk should decline as retirement approaches, but once through the period when sequence of return risk is highest, the portfolio should get more and more risky in retirement. Others contradict that completely and advise a declining exposure to equities after retirement.
Sleep at Night : After reading the above, it is reasonable to conclude that all the contradictory experts' advice should be ignored. Use common sense instead.
Your mental toughness during the years of asset accumulation may make you think that in retirement you can still tolerate a high weighting in risky assets. But after retirement you experience a MUCH lower tolerance for losses because your safety blanket (job) has been taken away. While in the working world, any losses can be shrugged off with "Oh well, I guess I'll have to work another year." But after retirement, when returning to work is not realistic, those losses cannot be recovered. To make things worse, you will extrapolate your poor returns out into the future thinking "Is this going to be the new normal?" Retirement will change you.
Mental Competence : Different asset types and investing strategies require different levels of attention and mental competence. Although experience makes us wiser, the doctors say that after age 50 the benefits of experience are off-set by the degradation of our cognitive function - even in 'normal' people with no clinical dementia. Will we see this in ourselves? If we see this in the spouse who manages our money, will we be able to convince him to give over control? Doctors say that in general retirees -
- are hyper loss averse with lower capacity to deal with risk and uncertainty.
- set aside rational decision-making and defer to supposedly expert opinion. They give-over responsibility and are susceptible to uncritical trust of experts.
- have reduced cognitive ability to grasp and integrate the implications of financial decisions.
- focus on the easier aspects of a decision (e.g. an apples to apples comparison) and ignore the harder aspects (e.g. an apples to oranges comparison of product attributes).
Younger retirees with all their faculties are still subject to the same emotional bad decision-making all of us fight. Even when not driven by emotions, we are subject to inertial. It has been shown that the decision at retirement to either actively invest or buy an annuity is determined according to whether the person is 'confronted' with the decision. People with Defined Benefit pensions are forced to decide whether to take the cash instead. They usually choose to stay with the annuity. People without a DB plan, who are never forced to make the decision, are unlikely to buy annuities.
How Much You Can Spend?
Some Possibility of Outliving Your Wealth Accepted
There ais a long list of ways to determine how much is safe to spend in retirement. They can be broken down between those based on probabilities of failure (an acceptable possibility of running out of money), and those based on the certainty of never running out of money. This section lists the former.
How much you can spend is usually thought of as a percent of your portfolio's value - the Safe Withdrawal Rate (SWR) -- Don't be too impressed by 'proofs' generated by Monte Carlo or Bootstrap simulation. These two article1 and article2 discuss their pros and cons. These software programs are far from perfect models of reality. Small changes in the withdrawal rate have huge impacts on the required nest egg calculated. A 4% withdrawal rate means your savings must equal 25 times your planned spending. A 3% withdrawal rate mean your savings must equal 33 times your planned spending (100 / 3).
Most all discussions concern the withdrawal percentage at retirement. But as you get older and closer to death you can take more chances (unless you still need the capital for end-of-life health care). The SWR in US history of a 50:50 portfolio of debt and equity increases exponentially with age.
Assume Zero % Investment Returns : . In other words, you plan to live off principal without relying upon earnings, and die broke. This calculation would not be used at retirement for planning, but it is useful for assuming a worst-case scenario. E.g. if you have experienced a few years of investment losses, or if inflation zooms higher. Open the spending spreadsheet. Using the default Inputs, change only the Rate of Return to 0.0%. The resulting Die-Broke scenario shows you can spend $17,830 (growing with inflation) with a $1 Million portfolio - a 1.8% withdrawal rate.
This model still has the possibility of failure. Your presumptions of inflation may be too low. You may actually invest in risky assets that suffer losses. You may live longer than modeled.
100% Divided by # years to 100 (or your longest expected lifespan) :
This calculates the amount you can spend assuming you die broke, and your portfolio's profits need only be sufficient to fund inflation's increases to your spending and to pay the taxes on those earnings The 50 year old who retires early can spend 100% / 50years = 2%. The 65 year old can spend 100% / 35years = 2.9%.
Of course you predict that your portfolio profits will be much larger, because you are not actually wanting to die broke. But you use this low assumption of profits as a worse case scenario. Notice that this calculation involves no variables for your asset allocation between debt and equity.
The 4% Solution :
It is important to understand some of the details behind the 4%
withdrawal rate frequently promoted. This was the result of work done
in 1994 ("Determine Withdrawal Rates") by William Bengen. He found that historically a 4% withdrawal (that grows with inflation) rarely depleted the portfolio before
30 years. It was the 'big events' that caused portfolios to fail - the Great Depression, the 1970's inflation, the 2000 tech bubble overvaluation. Since these big events only occur infrequently,
you may not want to be THAT certain. Then again, his time frame for study was only
30 years. If you are retiring early, 40 years will give you more time to run into these big events.
SpitzerSingh clarified with bootstrap analysis that over 30 years, a 4% draw rate on a portfolio of 70% or 80% equities would only run out 2% of the time, if the draws were taken first against the bonds portfolio. He also showed that the average remaining portfolio at the end of 30 years will be more than 7 times its original value. So if the sky does NOT fall, the 4% draw rate allows your portfolio to grow for your survivors.
It can be argued that 2011 markets are much more fragile than historically - that 'big events' will happen more frequently. Interest rates are so low that they can only rise (leading to capital losses). Dividend yields are far below historical rates. Company growth that was supported by the US consumer's borrowing has hit a brick wall. The ability of business to take for itself an increasing share of GDP (from employees) has hit its limit. Maybe the 4% that worked in history won't work going forward. Pfau's spreadsheet mentioned above indicates a much lower SWR (2%) for 2011 retirees.
There are many variations on the Buckets approach. The generic description is to fully fund the first 10 years of retirement with the principal and interest of super-safe government bonds or CDs. The amount needed can be predicted because their principal is guaranteed.
You own another bucket of assets to fund the second 10 years of retirement with its income and principal. These assets must produce a greater income because inflation will have started to hurt. These are still relatively 'safe' assets.
Your last bucket holds common stock equity. It must pay for all the remaining years of your life and must have growth. The argument used is that "Because you won't touch this bucket for 20 years, it is safe to stuff it with risky assets. Time dissipates risk." The problem is that this risk can be looked at two ways. Refer back to the discussion of price volatility on the Risks page. The Buckets people look at the risk of low returns as in Siegel's chart. But the retiree will face the unknown and hugely variable terminal value as shown in the second diagram.
The cost of funding the first 20 years with low return safe assets means you cannot retire until you are very wealthy. And you may end up with very few remaining assets when they are exhausted.
The Flexible Solution : A lot of problems are solved when retirees keep their spending habits flexible. They take an extended trip after market returns have been good, and cut back to basics in down markets. By doing so, the reverse-dollar-cost-averaging effect is not triggered. They budget for 'normal' health without touching the inflation-adjusted principal of their portfolio, so that a pot of value is available for end-of-life care. If they have the good fortune to retire after exceptionally great stock market returns, when interest rates are probably high, they crystallize those values with an annuity. If they retire after poor stock market returns with a smaller portfolio, they recognize that the next market upswing will increase their returns and portfolio and income.
The Reservoir System : Funding for spending comes from a pot of ready cash that is not invested. The account should start out able to fund about five years' of living costs, so work one extra year before retirement to create it. Each year you can spend about 1/5th. Each year you top it up with whatever your portfolio earns in excess of inflation. After a year of investment losses you don't add any more until the investment portfolio has regained its inflation-adjusted value. The pot works like a water reservoir. It buffers the variable investment returns so your cash usage can stay steady. If the cash account runs out, only then do you raid the portfolio for funds. You can see how this has worked through history with US and Canadian stock returns on the tab of the Spending spreadsheet called "ReservoirTotalReturn". It survives better and longer than most complicated academic models.
You can estimate at retirement what percentage of your portfolio will be available for spending using your own history of returns.
- Start with your portfolio's expected return percentage (e.g. 8%)
- less taxes at the rate for your circumstances (e.g. 15% of 8% equals 1.2%)
- less reinvested inflation (e.g. 2.5%)
- less 1% set aside for a rainy day (reverse-dollar-cost-averaging effect or sequence-of-returns risk)
- equals $$ available for spending ( = 3.3%).
When investments are losing money you make a judgement call. The pot may be much bigger than you need anyway because of past great returns - so 1/5th of the depleted pot is still sufficient. Or tax recoveries may top up the pot instead. Or cutting back expenses will keep you within the depleted 1/5th. Or you decide that the markets are making only a temporary correction - so spending need not be cut. Or you decide that at your age it is OK to start drawing down principal. As you get older you have a shorter expected lifespan and less longevity risk. You don't need the full inflation-adjusted-original-value of your portfolio. You probably don't even need the same nominal value you retired with.
How Much You Can Spend?
Outliving Your Wealth is UNACCEPTABLE
Buy an Annuity :
Most people should buy longevity and rate-of-return insurance with an annuity. The benefits will be higher than any SWR calculation because risks are shared. You can buy flat $$ payments, or payments that increase at a set percentage, or payments that increase with inflation. The only risk you are left with is inflation risk if your annuity is not inflation-adjusted. No one advises you to spend all your wealth on an annuity, because you will need free cash for emergencies and end-of-life-health-care. But annuities are great for covering your basic cost of living not funded by annuity-like government programs.
Make Your Own Annuity :
You can create your own annuity to protect against longevity risk, even though it will not benefit from mortality credits. Because this model will cost more, it is only be an option for those people loath to give away their hard earned wealth without any guarantee they will get it back. Each year's allowed withdrawal is freshly calculated to include the current value of your portfolio, the current yields of Real-Return bonds, and your longest expected life-span. The calculation uses the basic Present-Value-Of-An-Annuity calculation where you solve for the Annuity variable. Alternately you can choose to use for your lifespan the average of your personal longest estimate and the population's average.
Spend Same Percentage :
Your portfolio is guaranteed to never run out of money when your withdrawals are some set percentage that does not change from year to year. You may start with a 4% draw in year one. But if your investment experience a 10% loss, then your draw the following year is also 10% smaller because you draw 4% of the smaller portfolio.
This model is simple to understand and implement, but the constantly changing withdrawal amounts must be dealt with using some kind of reservoir for smoothing. Choosing a large original percentage can rapidly deplete the portfolio, leaving very small future withdrawals, even while their percentage stays constant and the portfolio still exists. Inflation can hit you from two sides. Rising inflation can cause stock prices to fall (reducing your withdrawal) even while your cost of living is increasing.
Spend Dividends Only :
There is a large group of people who have a religious belief in the wonders of dividend-paying stocks. They believe you can retire when the portfolio you own throws off enough dividends to cover your current expenses because those dividends won't be cut and they will grow with inflation.
If you look at the chart of the historical SWR (bottom of Pfau's spreadsheet). You can see that the dividend yield formed a very solid floor. Sometimes the SWR exceeded the dividend yield, but it almost never went below it. His calculation for the SWR current in 2011 is again down near the dividend yield OF THE WHOLE MARKET.
Problems arises when people presume that owning a portfolio of higher-yield stocks will allow them to retire earlier or spend more. They cherry-pick for the largest dividends. But the higher yields mean lower growth that may not keep up with inflation. E.g. Someone retiring at the end of 1968 presumed a 6% withdrawal rate was safe because his portfolio's dividend yield was 6%. The market yield at the time was about 3%. His $$ spending increased each year with inflation, and he owned the portfolio decile that yielded that income.
The portfolio failed in the 15th year. It could have been maintained if spending increases were limited to only 55% of inflation. But in that case, after 30 years, $$ Spending would have lost 50% of its purchasing power. The data comes from the Spending Spreadsheet tab called 'SpendYield' . Because the stocks' prices go up and down, their yield at each year end changed. Instead of using the large index %returns, the Fama-French data provide an estimate of the return each year for the decile appropriate for that yield. Right click to enlarge.
That said, play with the spreadsheet using different withdrawal rates and starting in different years. You will see that this strategy did better than the alternate index-based withdrawal strategy a lot of the time.
Another problem is that the true-believers hold no other safe asset class like debt or even cash. Debt doesn't yield as much as high dividend stocks (in 2011), and they believe they have no need for debt's stabilizing effect on the portfolio's value because they intend to never sell shares. They believe near-cash is not necessary because the company does their budgeting for them.
Non-believers would argue that
* Companies can and do cut their dividends.
* Market values cannot be ignored because emergencies do happen and people do end up in costly nursing homes requiring liquidation of the portfolio.
* Companies evolve and even die. The blue-chip of today may not exist in 10 years. Stock prices matter in the end.
* A higher dividend comes at the cost of lower growth that will reduce later dividend increases.
* A past history of increasing dividends does not guarantee future increases. When past increases have come from increasing the payout ratio, there is no longer room for future increases.
* The taxes on capital gains are irrelevant for the vast majority of people who hold their savings in tax-sheltered accounts.
* Concentrating all your wealth in one asset class exposes you to predictable risks - especially when the portfolio is largely ignored.
* It is far easier to claim you will ignore the value of your portfolio than it is to actually do so. Ignoring values will only ensure that by the time a dividend is cut and the decision to sell is made, the stock's price will be rock bottom.
Articles of Interest
The original Trinity Study by Cooley, Hubbard and Walz
The Trinity Study updated to 2009
"Making Money Last" by Peter Lingane
"Adaptive Withdrawals" by Spitzer, Strieter, Singh
"Withdrawal Plan Layer Cake" by William Bengen
"Replace Lost Longevity Insurance" by Moshe Milevshy
"Social Security Myths" Compare PAYGO public pensions to fully funded ones. And then to defined contribution individual plans.