How To Ensure Your Wealth Lasts During Retirement

How long will your nest egg last? Everyone who considers retirement asks that question. The question is more important as the bear market stretches on and the government confirms that life expectancy continue to increase.

Long lives and an extended bear market highlight a shortcoming in many retirement plans.

The traditional retirement plan assumes an annualized rate of return on investment assets. The plan is developed using a reasonable long-term rate of return (such as 8% or 9%) based on the long-term returns of the markets. Then the plan assumes that the investment accounts earn that rate of return each and every year.  A little number crunching on the computer using those assumptions determines whether or not you have enough money to pay for your spending plans.

The real world doesn’t work that way, as we learned the last few years. The way the real world works can dramatically change the results of a retirement plan. The stock market earns gains or 20% or more some years and has losses of 20% or more in other years. Most years it is somewhere in between.

This difference doesn’t matter if you were retired for a few years before a serious bear markets occurs. The results can be dramatically different, however, if the bear market occurs in the first few years of retirement.

Let’s look at a long-term period that includes both the best and worst investment returns since the Depression, 1968 to 1998. The average annual return for the S&P 500 during this period was 11.7%, well above the historical average. The early part of this period, however, was especially tough for investors. The stock market had several sharp declines, losing 50% of its value in one two-year stretch in the early 1970s, and bond prices suffered because of inflation.

A retiree who started with $250,000 and who knew the average annual return going forward would be 11.7% would have forecast a rosy retirement. He would calculate that he could withdraw 8.5% of the portfolio the first year and increase that by 3% each year without running out of money. In fact, his net worth would have increased over 20 years.

The actual returns, however, generated a completely different result. The average annual return was the result of above average returns after 1981. Unfortunately, because of sharp losses in the early years the investor’s portfolio would not last until 1981 to reap those high returns. The retiree would run out of money by 1981 if he withdrew an amount equal to 8.5% of the portfolio the first year and increased that by 3% each subsequent year. A much more attractive result emerges if the stock market returns were reversed, with the high returns in the early years of the period and the low returns at the end of the period. In that case, the portfolio has more money after 20 years than was anticipated using the average annual return.

Since we are living through another worst-case scenario similar to 1968 to 1982, retirees and prospective retirees would do well to set aside average annual returns for a while. Instead, ask the question: What is the maximum amount I can safely withdraw each year and not risk running out of money in a worst-case investment scenario?

I used the period beginning in 1968 to answer that question. I wanted to determine what adjustments needed to be made to ensure that a portfolio would last 30 years.

The result is that the first-year withdrawal should be no more than 4.1% of the portfolio’s value. The withdrawal can increase by 3% each year to keep pace with inflation.

Keep in mind that the 4.1% withdrawal rate is computed before taxes. You would have less than 4.1% to spend, because taxes would be due on income and capital gains earned. The taxes would depend on whether the money is invested in taxable or tax-deferred accounts.

This is consistent with other studies. Studies I’ve seen concluded that 4% to 5% of a portfolio’s initial value is the most that can be withdrawn if you want to ensure that the portfolio lasts through retirement.

You can perform a personal study of this type by visiting T. Rowe Price’s web site.

The results, remember, depend on the assumptions used. These results assume retirement begins at the start of the worst period of market returns since the Depression, before the latest three years. In addition, the market had below-average returns for years after that. After 1982, however, the market had above-average returns. High inflation also reduced bond market returns during this period.

Because of these results, anyone who retired the last few years or who will retire soon might want to consider changes if he or she is spending more than 4% to 5% of the portfolio annually.

But don’t automatically slash your spending. There are other factors to consider.

First, examine your portfolio. The studies simplify things by using only the S&P 500 index, a bond market index, and treasury notes. Higher returns (meaning smaller losses) can be achieved by adding small company stocks, international stocks, annuities, high yield bonds, and real estate investment trusts. Certainly if you have been following my recommended portfolios the last few years you have performed better than these indexed portfolios.

Also, consider that spending tends to decrease in the later years of retirement because people tend to slow down sometime between ages 75 and 85. To keep from depriving oneself in the early years of retirement a retiree might want to maintain a standard of living now and expect to reduce spending later.

If the bear market continues or your portfolio performs poorly, then consider reducing some expenses. Non-fixed expenses often can be reduced easily. Small changes such as postponing some planned travel or eating more meals at home can offset poor investment returns.