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Preparing for Retirement
(Updated 4/21/08)
Introduction After a lifetime saving and investing the hard-earned dollars they’ve accumulated during their career, soon-to-be retirees will be faced with the task of generating the income to carry them through retirement. This article will outline the steps for you to follow as you formulate your plan. Central to the plan will be to determine your income gap, if any. The first step is to determine your annual expenses. Next, add up the annual income you will receive from social security and any pensions. If there is a gap, the shortfall will have to be generated from your retirement portfolio. Step 1: Determine your annual expenses If you’ve been tracking your expenses, this step should be relatively easy. Otherwise, you’ll need to go through your financial records such as your check register and credit card bills. I know this may be a chore. But knowing your annual expenses is important information to have in order to safeguard against running out of money too soon. Step 2: Add up your annual income Every year, the Social Security Administration mails a statement with an estimate of the benefits you’ll receive. You can also visit their website and use their Benefits Calculator. If you’ll be receiving a pension, check with your human resources department for how much you will be getting. And ask if the payments will include an annual cost-of-living adjustment. Step 3: Will there be an income gap? If social security and a pension covers your living expenses, congratulations! Consider yourself fortunate. However, you’re not out of the woods just yet. If your pension check won’t be adjusted for inflation, an income gap may develop which may widen in future years. Even at a low average rate of inflation like 3%, your purchasing power will be cut in half some 24 years from now. What this means is that a dollar’s worth of income today that doesn’t rise with inflation, will be worth only 50 cents in 24 years, if we assume an average inflation rate of 3%.
The potential income gap arising from a pension not inflation-adjusted will need to be filled by your retirement portfolio. Unlike an inflation-adjusted pension, the calculation to determine the portfolio size you will need with a non-inflation-adjusted pension is not as easy. It may be wise to consult a competent fee-only financial planner to help you. Or you may try an online calculator called FIRECalc. This calculator has an option to enter a non-inflation-adjusted pension. If your income from social security and an inflation-adjusted pension (if any) falls short of your annual expenses, it is easy to calculate your income gap. Simply subtract your annual expenses from your annual income. This is your income gap. The discussion that follows will show how to fill that income gap from your retirement portfolio. (Taxes on interest, dividends, capital gains and distributions from regular IRAs or 401(k) plans will not be discussed. However, you will need to make an estimate of those taxes and include them in your annual expenses.) Step 4: Filling the income gap You may have heard of the infamous 4% withdrawal rate. That’s the “rule of thumb” of what might be generated from a balanced portfolio (50% stocks and 50% bonds) and sustained over a 30-year period. As an example, if your income gap in the first year of retirement is $30,000, your retirement portfolio needs to be at least $750,000. An alternate rule of thumb is to multiply your income gap by 25 (or $30,000 * 25 = $750,000).
You may be wondering, “Where did this 4% withdrawal rate come from?” It comes from looking at the historical data for stocks, bonds and inflation. This analysis looks to see how much money can be withdrawn each year, adjusted for inflation (or deflation), while still having something left after 30 years. The maximum initial withdrawal rate that “worked” using a 50/50 stocks/bonds portfolio was 4%. The maximum initial withdrawal rate is sometimes referred to as the “Safe” Withdrawal Rate (SWR).
This chart was created using my Maximum Withdrawal Rate Spreadsheet (xls) See note 1 for a detailed explanation. Now you may be wondering, “Why use a 50/50 portfolio?” And, “Why use 30 years?” In answer to the first question, a 50/50 portfolio is chosen based on historical data.
Data obtained from my Maximum Withdrawal Rate Spreadsheet (xls) This makes intuitive sense. While bonds generate steadier income than stocks, bonds also have lower historical returns than stocks. Therefore, retirees shouldn’t skimp on stocks if they want their money to last and to keep pace with inflation. In answer to the second question, 30 years is chosen to encompass the estimated lifespan of the vast majority of 65 year-olds entering retirement.
Data obtained from United States Life Tables, 2004 (pdf) on the National Center for Health Statistics website To repeat, an initial withdrawal rate of 4% and adjusted for inflation is an estimate of what might be generated from a balanced portfolio and sustained over a 30-year period. But what if you retire earlier than or later than age 65? Will the “safe” withdrawal rate be different? The answer is ‘yes’ as shown on the following chart:
Data obtained from my Maximum Withdrawal Rate Spreadsheet (xls) Now realize that this was a simple 50/50 portfolio with the equity side composed of only the S&P 500. Later studies have shown that adding other stock asset classes like value stocks and small stocks improved the initial withdrawal rate. ( See note 2 ) The improved initial withdrawal rate makes sense for two reasons. First, value and small stocks have had higher historical returns than the S&P 500.
Source: See note 3 Second, Modern Portfolio Theory (MPT) predicts that a more widely diversified stock portfolio that includes low-correlating assets should deliver higher risk-adjusted returns (or similar return at lower volatility). In other words, in a widely diversified portfolio, when one stock asset class lags, another might be leading. This should result in a more stable portfolio. Just to explain the point a little further, a more volatile portfolio runs a greater risk of running out of money. This makes intuitive sense. If the portfolio declines, you’ll be “selling low”. Do that too often over the course of a 30-year retirement, and the portfolio probably won’t recover enough when good returns eventually come. To get an idea how different levels of volatility affect a portfolio in retirement, try this Monte Carlo calculator. Actually, volatility in and of itself is not necessary bad. Rather, it is whether poor returns show up either in the early years or in the later years. This is the more serious problem that results from a volatile portfolio in retirement. In the case where a retiree is lucky enough to get robust returns in the early years, he won’t have to worry so much even if the returns toward the end of retirement are sub-par. However, reverse the order with sub-par returns in the early years rather than the later years, and the retiree may not have much room for error to maintain an initial 4% withdrawal rate. See note 4 for a more detailed discussion of how poor portfolio returns in the early years of retirement affect maximum initial withdrawal rates. So even though a more widely diversified retirement portfolio might provide a higher initial withdrawal rate, I would still recommend sticking to a 4% initial withdrawal rate. It may be prudent to be a bit conservative should stocks generate returns lower than in the past. In fact, I believe it may be wise to build in some flexibility, as well, into one’s retirement withdrawals. The conventional method is to take that initial 4% in the first year and then increase the amount every year for inflation. Perhaps my conservative nature is showing. But for myself, I would be more comfortable with a variable withdrawal -- one that takes into account the amount of the total portfolio and whether it is growing or shrinking too fast. My favorite variable withdrawal strategy is William Bengen’s “Floor and Ceiling” approach. See note 5 for a detailed description. (Other variable withdrawal strategies can be found in an article I wrote HERE.) If I were to retire today, I would have my budget split into two parts: essentials and discretionary. Let me put up some numbers to show as an example. Let’s say I had $20,000 coming in from Social Security and an inflation-adjusted pension. And let’s assume that my total annual expenses were $50,000. The income gap of $30,000 will come from my balanced retirement portfolio of $750,000. This, by the way, is the famous 4% withdrawal rate ($30,000 / $750,000 = 4%). Furthermore, let’s say my “essentials budget” is $45,000 and my “discretionary budget” is $5,000. In other words, 10% of my expenses are discretionary. These amounts would rise each year for inflation. This means that my retirement portfolio has to generate at least $25,000 and rise annually with inflation. ($45,000 essential expenses minus $20,000 from Social Security and pension = $25,000) This $25,000 would represent an initial withdrawal “floor” rate of 3.3%. ($25,000 / $750,000 = 3.3%) So even in the worst case when the portfolio performs lousy, I know I will have the essential expenses covered. Step 5. What to do if you come up short If you're unable to fill the income gap, there are still some things you can do. For example, work a little longer at your full-time job or get a part-time job. This could boost your retirement prospects in four ways: First, by delaying withdrawals, you allow your retirement portfolio to continue growing. Second, by working, you may be able to add to your savings. Third, by retiring later, you will reduce the number of years your nest egg has to generate income. And finally, by delaying the start of social security payments, you will boost the size of the monthly check you’ll receive. Other options to fill the income gap include downsizing to a smaller home or taking out a reverse mortgage. Click HERE to learn more. Another option to consider might be to purchase an immediate annuity with a portion of your retirement portfolio. While immediate annuities provide higher predictable income, you need to weigh the Pros and Cons carefully. Conclusion Like any long journey, it pays to plan the route. And the next 30 or so years spent in retirement will require a well thought-out plan to generate enough income to carry you through your golden years. This article outlined the steps to help you prepare your retirement plan. However, if you feel you need more help, it may be wise to hire a competent fee-only planner to assist you. |
| Note 1 | The following chart shows maximum initial withdrawal rates for 30-year periods with a portfolio consisting of 50% large stocks (S&P 500) and 50% bonds (5-year Treasuries).
This chart was created using my Maximum Withdrawal Rate Spreadsheet (xls) Each data point represents a single 30-year period. For example, the value of the first data point (red dot) is 7.28% and represents the maximum initial withdrawal rate for the 30-year period from 1926 through 1955. Likewise, the lowest maximum initial withdrawal rate had a value of 4.03% (yellow dot) and occurred during the period from 1966 through 1995. And just to be complete, the highest maximum initial withdrawal rate had a value of 7.77% (purple dot) and occurred during the period from 1949 through 1978. The lowest maximum initial withdrawal rate is sometimes called the “Safe” Withdrawal Rate (SWR).
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| Note 2 | The following articles are historical studies that have examined “safe” withdrawal rates using widely diversified portfolios.
Portfolio Management for Retirees: Is the 'Safe' Initial Withdrawal Rate Too Safe? Decision Rules and Maximum Initial Withdrawal Rates
When Your Portfolio Starts Paying You
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| Note 3 | Data obtained from Fama/French Benchmark Portfolios - Annual (txt) in the Ken French Data Library.
“Small” is the small-blend (S/M) data series.
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| Note 4 | I started my analysis by comparing maximum initial withdrawal rates with the first 5 years real returns in each 30-year period.
Then I looked at the first 6 years, the first 7 years, and so on. It turns out that the first 13 years real returns of each 30-year period most closely correlates with maximum initial withdrawal rates.
The next chart plots the first 13 years real returns of each 30-year period (shown in bars) and maximum initial withdrawal rates (line).
Data obtained from my Allocation Spreadsheet (xls)
and my Maximum Withdrawal Rate Spreadsheet (xls)
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| Note 5 | William Bengen’s “Floor and Ceiling” strategy appears in this article: Conserving Client Portfolios During Retirement, Part IV
The withdrawal amount is calculated as a percentage of the portfolio’s total value. The withdrawal amount is allowed to rise or fall with the performance of the portfolio. However, the withdrawal will neither fall below a “floor” nor rise above a “ceiling”. Both the “floor” and “ceiling” are adjusted upwards for inflation. As an example, the initial floor can be set at 3.6% and rise with inflation. And the initial ceiling can be set at 5% and rise with inflation. The withdrawal amount can be set initially at a fixed percentage like 4%. On a $1,000,000 portfolio, the withdrawal will not fall below an inflation-adjusted amount of $36,000. Nor will the withdrawal rise above an inflation-adjusted amount of $50,000.
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