2006 is a significant year for baby boomers (those of us born between 1946 and 1964). The first baby boomers turn 60 this year - kindling thoughts of retirement. If you are in this group and have saved wisely over the years, investing in retirement accounts and accumulating a significant portfolio, how much can you safely withdraw from these accounts each year without fear of running out of money during a “normal” retirement time horizon? Unfortunately, probably less than you might think.
Let’s assume that:
- You have accumulated $1,000,000 in tax-deferred retirement accounts
- Long-term stock returns are expected to be 9% per year - a little lower than the average return during the past 80 years or so (with a standard deviation of 20% - a measure of the volatility of returns)
- Long-term government bond returns are expected to be 5% per year (with a standard deviation of 9%)
- Long-term inflation is expected to be 3%.
If you invest 100% of your portfolio in stocks and desire to withdraw enough each year such that the remaining funds are reinvested to increase future payments by the rate of inflation, you might assume that you could safely withdraw $60,000 (9% minus 3% inflation) the first year, $61,800 the second year, and so on, without ever running out of money. Unfortunately, this is only possible if stocks had a return of 9% every single year with no variability. In reality, stock returns are variable and several years of consecutive losses can occur – impairing your ability to maintain withdrawals at the planned level. Using historical volatility, the above assumptions and software which permits running many possible scenarios reveals that if you invest 100% of your portfolio in stocks you actually have about a 50% probability of running out of money within 30 years (withdrawing $60,000 each year adjusted for inflation).
A 50% probability of running out of money is not very attractive. Using the same software we can determine that the maximum “sustainable” withdrawal amount which would reduce the probability of running out of money in 30 years to 10% is about $27,500 adjusted for inflation!
What if we had invested in long-term government bonds instead? The maximum “sustainble” withdrawal amount (keeping the probability of running out of money within 30 years at 10%) is about $29,000.
While stocks have historically had higher returns they are more variable, bonds provide a higher sustainable withdrawal amount. However, while the sustainable withdrawal may be higher for bonds the average wealth accumulation in the event you don’t run out of money is expected to be lower (less money on average to leave to your heirs if that is one of your objectives).
As noted in earlier posts, diversification is important. It is especially helpful during retirement. Using the above assumptions, consider the following portfolios and the maximum sustainable, inflation-adjusted withdrawal (keeping the probability of running out of money within 30 years at 10%):
70% Stocks/30% Bonds $32,000
50% Stocks/50% Bonds $34,000
30% Stocks/70% Bonds $34,000
By diversifying between stocks and bonds you can improve the sustainability of your retirement withdrawals! Once again this demonstrates the benefits of investing in different asset classes that do not always move in the same direction rather than putting all of your eggs in one basket. This example only considers two assets classes (stocks and bonds). Further improvement can be made by including other assets classes such as real estate investment trusts and international securities. Sustainable withdrawals can also be enhanced by using risk reducing techniques such as a covered call strategy (more on this on a later date).
As always, your asset allocation will depend on your risk tolerance, current market conditions and expectations. Also your asset allocation during your pre-retirement (accumulation) years is likely to be different that your asset allocation during retirement (distribution) years. During pre-retirement years more volatility can be tolerated as annual distributions are not being made.