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Retire at the Pie Shop
(Updated 8/31/06)
Preface A Very “Safe” Withdrawal Strategy I had already completed writing this article. So, this preface was written last. When I started writing this article, I had assumed that a retiree would have some mix of stocks and fixed income in order to provide a sustainable and “safe” withdrawal rate for the duration of his retirement. Then, I had a conversation with a retiree whose risk tolerance is extremely low. He could not bear the thought of any volatility to his nest egg. He didn't want any stocks in his portfolio. In this case, there is really only one solution. And that solution would be to fully fund the nest egg with enough fixed income investments to last his entire lifespan during retirement. Here’s how it might work. Let’s assume you retire at age 65. And let’s say that you might live for 30 years. So, simply multiply your annual expenses times 30. That will be the amount you will need at the start of your retirement. (I excluded social security or any other income sources for the sake of this example.) Let’s put up some numbers just make this clear. If your expenses are $40,000, you will need $1,200,000. This comes out to be an initial 3.3% withdrawal rate. You may say that this is too simplistic. And that there should be some provision for inflation and earning some interest on the money in the portfolio. You would be correct. But both calculations would produce about the same result. Just to show you, let’s try a “realistic” example. And use a 3% inflation rate and a conservative interest rate of 3%. The answer also turns out to be $1,200,000.  However, as you can see that at the end of year 30, the balance of the entire portfolio is spent. Personally, I would be uncomfortable with this prospect. I suppose we could add more money to the original $1,200,000 that we started with. But then I would be asking myself, “How much more would be enough?” That’s a tough question to answer. So many things can happen (bad things). We can't know in advance what might happen in the future. Will inflation become a problem? Will there be unexpected expenses? To my mind, I would rather trade the certain prospect of using up a stable nest egg with the potential of sustaining my nest egg -- even if this means that my nest egg will be subject to the volatility that comes from investing in the stock market. This is the trade-off that each retiree has to decide on. As I will show in the first chapter, a balanced portfolio (stocks and bonds) has been shown to “safely” sustain inflation-adjusted withdrawals from an initial withdrawal rate of 4%. Is a 4% withdrawal rate foolproof? No one knows what the future will hold. But if history is a guide, the odds are very good. This is not to say that there haven’t been “close calls” in the past. William Bernstein has looked at one such “close call”. The 30-year period starting in 1966 was about as bad as it ever got in the post-World War II period. During that 1966-1995 period, large cap stocks had an initial stretch of very low returns before the Great Bull Market began in 1982. Then, of course, there was the dismally high inflation of the 1970’s. Bernstein takes you back through it in an article he wrote which you can read here. If I haven’t thoroughly discouraged you yet, then you may be ready to learn about the approach that I have developed to sustain a nest egg during retirement. My method incorporates three simple principles: 1) For the stock portion of your portfolio, diversify across several asset classes via separate mutual funds.And now, let’s begin. Introduction In the discussion that follows, I will show how to apply a “safe” withdrawal rate from a retirement portfolio consisting of a collection of index funds from different asset classes. The topics I will be covering include: • Increase annual withdrawal to maintain inflation-adjusted purchasing power After reading a few books and numerous articles on the subject, I have a deeper understanding of the issues involving withdrawing from a retirement portfolio. This article will go into great detail with many examples. Historical Rates of Returns The first step to understanding the process is to make reasonable assumptions about rates of return. In the next few chapters, I will review historical rates of returns for stocks, intermediate-term bonds (5 years), cash and inflation. Briefly, these can be summarized with approximate numbers: Large-cap stocks 11% Growth Rate for a Balanced Portfolio A reasonable assumption for a balanced portfolio would be as follows: • Have 50% in stocks with an expected average rate of return of 10%. With these assumptions, a balanced portfolio can roughly achieve an overall average rate of return of 7% calculated as follows: 50% stocks x 10% = 5% So adding 5% return from stocks plus 2% return from fixed income would generate an overall average return of 7%. Calculating a Withdrawal Rate So now we have two key numbers. First, if we want our nest egg to keep pace with inflation, it must grow each year by 3%. (This assumes that your expenses will grow more or less in line with inflation. This topic can get very complicated. For example, health care expenses might grow much faster at a later stage in retirement. But for the sake of simplicity, I will use 3% in order to demonstrate this example.) Second, we have assumed that our balanced portfolio can grow at an average annual rate of 7%. The difference between the average growth rate (7%) and the average inflation rate (3%) is what we can “safely” withdraw (4%). Written as a formula: Initial withdrawal rate = (Portfolio average annual growth rate) – (Average inflation rate)
As I will show in the following chapters on historical returns, we can expect stocks to experience good years and bad years. So we need to be smart about how we take withdrawals from the portfolio. This is because withdrawing from declining stock funds can deplete your portfolio sooner than necessary. I explain this concept of “reverse dollar cost averaging” in this article.
$1,000,000 x 4% = $40,000 Alternatively, you will need 25 times the first year’s amount you require from your nest egg. 25 is the inverse of 4%. Further Reading In contrast with the large number of books written on how to accumulate a retirement nest egg, there are precious few books written on a strategy showing how to withdraw money from your nest egg and make it last your lifetime. And none really satisfies me in a way that I can fully recommend. This is the motivation for me to write these articles. There are many pieces of the puzzle from many different books and internet articles. And it’s taken me a long time to make all the pieces from these many sources fit together in a manner that I can be comfortable with. With that said, here are three books. Some ideas I found useful, some not so useful. The Grangaard Strategy: Invest Right During Retirement by Paul A. Grangaard Plan Right for Retirement With the Grangaard Strategy by Paul A. Grangaard Buckets of Money : How to Retire in Comfort and Safety by Raymond J. Lucia In the next few chapters, I will review historical rates of returns. I’ll start this review with large-cap stocks as represented by the S&P 500. Data comes from Ibbotson. You can also find the data in The Grangaard Strategy: Invest Right During Retirement by Paul A. Grangaard This site also has historical data: www.gummy-stuff.org  As you can see in figure 1, annual returns are quite variable. But when taken over the whole period, the average annual return is around 11%.  Figure 2 shows a histogram of the returns. The blue numbers correspond to the percent of the pie. There were a total of 78 years in the entire period. For 5 out those 78 years (or 6%), annual returns were below -20%. For 23 out of 78 years (or 28%), returns were negative. For the optimist, nearly 3 out 4 years were positive. Let’s now examine small-cap stocks. Again, the data comes from Ibbotson.  You can see in figure 3 that the annual returns are more widely dispersed than for large-cap stocks in figure 1. Over the entire period, the average annual return for small stocks was approximately 12%.  Figure 4 shows the histogram of small-cap returns. Here we see the manifestation of the wider dispersion of returns. There are more years of negative returns (18 out of 78 or 32%). However, this was balanced out by more years with returns of 20% or higher. Next, let’s take a look at the annual returns for intermediate-term (5-year) government bonds. Again, the data comes from Ibbotson.  Figure 5 shows the combined results of income plus capital gain or loss. (The principle value of a bond will rise or fall with changes in interest rates.) An investor holding an intermediate-term bond mutual fund would likely experience similar volatility. Over the entire period, the average annual return was approximately 5%.  Figure 6 shows a histogram of the returns shown in figure 5. Eight out of the 78 years in the study (or 10%) had negative returns. Fortunately, an investor wishing to eliminate volatility in the bond component of their portfolio can easily do so. This can be accomplished by constructing a bond or CD ladder. Bankrate.com has an article on how to construct a CD ladder. Click here to learn more. The last series of historical returns will be for cash and inflation. The data shown in figure 7 comes from Ibbotson and represents the annual returns for 90-day treasury bills. Over the entire period, the average annual return was approximately 4%.  The final chart (figure 8) shows the annual change (year-over-year) of inflation. The data comes from the Bureau of Labor Statistics. For you data hounds, you can view the raw data here.  For the entire period, inflation ran at an average annual rate of 3%. Having reviewed the annual historical returns of common asset classes, you may have a better appreciation of their risks and rewards. The rewards of stocks are self-evident. They have higher average returns than bonds and cash. The risk is that is that stocks will experience negative returns over the short-term. And withdrawing funds from declining stock funds can deplete those funds sooner than necessary. I mentioned “reverse dollar cost averaging” in chapter 1, but you can read about it again here. One way to minimize the risk of declining stock funds is to hold a collection of stock funds that move differently from one another. So while one stock fund may be having a bad year, others might be going strong. That’s the great appeal of diversification and the reasoning behind the Coffeehouse Portfolio. Created by Bill Schultheis, the Coffeehouse Portfolio is composed of six stock asset classes plus fixed income.  Now you may notice that the stock:bond allocation that I’m suggesting is slightly higher than the 50:50 balanced allocation I described in chapter 1. And that’s fine. For your own personal allocation, you may tailor it to your own risk tolerance. For a more complete discussion on asset allocation and risk tolerance, you may read this article I wrote. But for now, I will use the 60:40 stock:bond allocation to make the examples easier to explain. However, let me get back to the discussion at hand which is diversification of stock funds. This can be demonstrated with the following charts. The first three charts are from www.coffeehouseinvestor.com 
 This chart first appeared here.  And finally, you must realize that a more diversified stock portfolio will at times perform differently than traditional benchmark indexes such as the S&P 500. So yes, there may be some years when a more diversified stock portfolio underperforms the S&P 500. However, it is likely that a more diversified stock portfolio (like the one that is part of the Coffeehouse portfolio) may outperform the S&P 500 over the long-term. As evidence, the following chart compares a diversified stock portfolio using historical data from DFA (an institutional fund family) and the S&P 500. The source of the chart can be found at www.fundadvice.com  DFA (Dimensional Fund Advisors) was founded by academics whose research lead to the creation of the “Slice and Dice” strategy. Let’s review what we’ve learned so far. Based on historical market data, a balanced portfolio (stocks and bonds) is capable of producing an average annual return of 7%. At this rate of return, we can both withdraw an initial 4% and increase withdrawals each year by 3% to keep pace with inflation (assuming an annual inflation rate of 3%). A 4% initial withdrawal rate will require our nest egg to be 25 times our first year’s expenses. Although stocks have higher historical returns than bonds and cash, they are subject to declines. However, withdrawing funds from declining stock funds will cause those funds to deplete sooner than necessary. This is referred to as “Reverse Dollar Cost Averaging”. One way to mitigate this problem is to have a collection of stock funds which move differently from one another. In this way, we can withdraw from just the gaining funds and leave the lagging funds alone until they recover. I will demonstrate how this strategy works. The Coffeehouse Portfolio will be used throughout. To keep things simple, taxes will not be a consideration in any of the following examples.  To keep the numbers easy, we will start year 1 with $1,000,000. With a 4% withdrawal rate, we will withdraw $40,000 in the first year. I chose conservative dividend rates for each asset class. You will notice that I split the fixed income component into 30% bonds and 10% cash. The large cash reserve is mainly for peace of mind. It’s nice to know that in case of some emergency a certain amount of cash is immediately available. However, it can be argued that 10% of one’s nest egg is perhaps on the high side to sit in cash. But I’m using 10% just to show as an example. If you prefer, a smaller cash allocation is also O.K. As I discussed in chapter 4, I believe it is best to use a laddered portfolio of individual bonds or CDs. This strategy will produce a higher overall yield while maintaining a stable value. Since the net asset value of bond funds will fluctuate with interest rates, I recommend them only for a very small part of your overall fixed income portfolio if they’re used at all. So at the end of the first year, this sample portfolio will produce $23,500 in dividends and interest. During our working years, we would normally reinvest dividends and interest in order to further grow our nest egg. But now during retirement, those dividends will help replace the regular paycheck we used to have while working. So the $23,500 will go toward our first year’s spending needs. We are more than half way toward our goal of withdrawing $40,000 and we haven’t even sold a single share from our stock portfolio! Let’s look next at an example of gaining and losing stock funds.  I arbitrarily had four gaining stock funds (up 15%) and two declining stock funds (down 10%). This produced total gains of $60,000. (We’ll look at the losses in the next figure.) So from our gains, we only need $16,500 to fund our first year’s withdrawal. We have $43,500 to reinvest.  Out of that $43,500, we will first replenish the lagging stock funds. We will then use the rest to rebalance.  The first sample year ended with our portfolio on a positive note. In the next chapter, we will walk through another sample year with a different scenario. As in sample year 1, we start drawing off the dividends. However, to keep pace with inflation, our annual spending needs have increased by 3%. So instead of withdrawing $40,000, we will instead withdraw $41,200.  Instead of mostly gaining funds, I’ve reverse roles. Now there are 4 losing funds (down 10%) and 2 gaining funds (up 15%).  Still, there was enough from the gaining stock funds to satisfy our second year’s spending needs. Plus there was a bit left over to redirect to the lagging funds.  Unfortunately, it looks like we’ll end sample year 2 less than where we started.  We haven’t covered all the scenarios one may encounter during retirement. But we have covered much of the basics. To give a more complete picture of the “Retire at the Pie Shop” strategy, what better way than to use actual returns? This is exactly what we will cover in the remaining chapters. In the following chapters, we will use actual fund returns from the Coffeehouse Portfolio. We will see the withdrawal strategy in action. I will walk you through the details every step of the way. So how did the Coffeehouse Portfolio perform during the last 5 years? Well, it’s relatively easy to find out. Vanguard provides fund returns on their website. The following table shows how each of the stock funds performed. However, for fixed income, I will substitute the bond fund with the same constant returns used in the examples shown in the previous two chapters.  We will start with a $1,000,000 nest egg and withdraw $40,000 in the first year. This is our initial 4% withdrawal rate. And then we will increase the withdrawals to keep pace with inflation. To keep the numbers relatively simple, I’ll just use 3% each year instead of the actual inflation rate.  Alright. We are ready to begin. And to make things more realistic, let’s pretend our employer gave us a retirement party on our last day of work on New Years Eve 1999. Feels good, right? You bet! So to celebrate the New Year and the first day of our retirement, we withdraw $40,000 and put it into our checking account that earns no interest (to simplify my examples). We will use the $40,000 to pay our expenses for the next 12 months.  Twelve months go by and our checking account is empty. Time to withdraw for year 2001. First, let’s gather the dividends and interest that have accumulated during the year.  Next, we’ll take profits from the gaining stock funds. The profits were more than sufficient to meet our Year 2001 spending needs.  The remaining profits are then used to replenish the lagging funds.  However, it looks like the value of those lagging funds will be less than what they started the year with.  We’re done with the first year of retirement. We’ve spent our first withdrawal of $40,000. We have our second year’s withdrawal of $41,200 in the bank. So we’re prepared for another 12 months. In the next chapter, we’ll do it all again for Year 2001. So year 2001 has come and gone. Here’s how the Coffeehouse Portfolio fared:  Last year, we withdrew $41,200. And to keep pace with a 3% inflation rate, we will need to withdraw $42,436. First, we will gather the dividends.  Next, we take profits from the gaining funds. The profits were more than sufficient to meet our Year 2002 spending needs.  The remaining profits are then used to replenish one of the lagging funds.  Once again, it looks like the value of those lagging funds will be less than what they started the year with.  Investors who routinely rebalance once a year may be tempted to do so now. Rebalancing certainly makes sense in the accumulation phase before retirement. However, now that we are in retirement, rebalancing at this point would entail selling some from our fixed income accounts. I would consider this action only for highly risk-tolerant investors. For this reason, I will leave the portfolio as is, even if it is a little lighter on stocks at 58:42. Let me spend a little more time explaining my philosophy so that you understand why I prefer to preserve fixed income whenever possible. A portfolio in retirement needs to achieve multiple objectives. On the one hand, we need a stable source of immediate income in the form of dividends and interest -- the bulk of which comes from our bond (or CD) ladder and cash. The fixed income portion also will provide a ballast against the more volatile growth-oriented part of the portfolio. This ballast can be a psychological anchor during bear markets so the investor will have the courage to stay the course until the next bull market. The other objective is growth (provided by our stock funds) so that our annual withdrawals can increase a little each year to keep pace with inflation. End of philosophical ramble. O.K. We’re done with the second year of retirement. We’ve spent our second withdrawal of $41,200. And we have our third year’s withdrawal of $42,436 in the bank. So we’re prepared for another 12 months. In the next chapter, we’ll do it all again for Year 2002. Year 2002 has come and gone. Here’s how the Coffeehouse Portfolio fared:  Last year, we withdrew $42,436. And to keep pace with a 3% inflation rate, we will need to withdraw $43,709. First, we will gather the dividends.  Unfortunately, there are no gaining funds this year from which to take profits from. So instead we will dip into cash to take what we need to meet our Year 2002 spending needs.  Here is how our portfolio looks at the end of 2002:  The portfolio certainly looks like it’s crying out for rebalancing. But, I will again leave it as is. I will explore rebalancing during bear markets in greater detail in chapter 14. We’re done with the third year of retirement. We’ve spent our third withdrawal of $42,436. And we have our fourth year’s withdrawal of $43,709 in the bank. So we’re prepared for another 12 months. In the next chapter, we’ll do it all again for Year 2003. Year 2003 has come and gone. Here’s how the Coffeehouse Portfolio fared:  Last year, we withdrew $43,709. And to keep pace with a 3% inflation rate, we will need to withdraw $45,020. First, we will gather the dividends.  Next, we take profits from the gaining funds. This time, the profits were more than sufficient to meet our Year 2004 spending needs.  The remaining profits are then used to replenish the lagging funds from last year.  Year 2003 was a big up year. This made a big impact on bringing our funds nearly up to where they started. Plus, the balances are almost to our target allocation.  We’re done with the fourth year of retirement. We’ve spent our fourth withdrawal of $43,709. And we have our fifth year’s withdrawal of $45,020 in the bank. So we’re prepared for another 12 months. In the next chapter, we’ll do it one more time for Year 2004. Year 2004 has come and gone. Here’s how the Coffeehouse Portfolio fared:  Last year, we withdrew $45,020. And to keep pace with a 3% inflation rate, we will need to withdraw $46,371. First, we will gather the dividends.  Next, we take profits from the gaining funds. The profits were more than sufficient to meet our Year 2005 spending needs.  Year 2004 was another big up year with no lagging funds. So this time, we will just rebalance.  We’re done with the fifth year of retirement. We’ve spent our fifth withdrawal of $45,020. And we have our sixth year’s withdrawal of $46,371 in the bank. So we’re prepared for another 12 months. The impact of bear markets is something that every investor must face and have a plan. The plan that I proposed was to have a widely diversified portfolio such as the Coffeehouse Portfolio. And we saw that the Coffeehouse Portfolio came through the recent 2000-2002 bear market relatively well. However, there are no guarantees. In fact, if you go back to 1973-1974, we saw that a similarly diversified portfolio, DFA, did not provide any protection from the bear market at all. Let me again show DFA returns from chapter 6. So if another such synchronous and extended bear market happens, what will be your plan? Let me also say that as someone who has lived through the painful 2000-2002 bear market, it will take enormous courage just to take any action. This is because all you read in the financial press is pessimistic news on the economy. And the general news is usually just as gloomy. So it will take a measure of faith to buy stocks should you choose to do so. And that is exactly what you will be doing if you rebalance in a bear market. This is because a bear market could take down your stock portfolio by a significant amount. By how much? Using past bear markets as a guide, perhaps by 50 percent. This was nearly the amount the S&P 500 dropped in the 2000-2002 bear market. So I will use a potential 50 percent drop when formulating my plan. And here is my plan. Once the stock portion drops by 30%, that will be my trigger to start rebalancing. I chose a 30% trigger point because it is more than halfway to the possible drop of 50%. Figure 48 shows how a 30% drop in stocks will impact a $1,000,000 portfolio. The top half of figure 48 shows that a 30% drop in stocks changes a 50:50 stock:fixed income portfolio to 42:58. Also notice that I take out $20,000 from fixed income. This approximates part of the annual withdrawal for our spending needs. Recall that in the examples in prior chapters, we started with a 4% annual withdrawal ($40,000). The other part of our annual withdrawal came from dividends and interest. And since there was a loss in stocks, they were left untouched.  Similarly, the bottom half of figure 48 shows how a 30% drop in stocks changes a 60:40 portfolio to 52:48. Notice that in both cases (50:50 and 60:40) the overall allocation shifted by nearly 8%. Let’s go back and look at the DFA returns. This time, I’ll just show the years with losses. I will also simulate how two portfolios with different allocations (50:50 and 60:40) would have turned out.   Notice that according to the DFA returns, the asset allocation of the 2000-2002 bear market was hardly changed. However, the 1973-1974 bear market produced a drastic change. And the decline in stocks went past my trigger point of 30%. So once a 30% trigger is tripped, what should the next course of action be? One option would be to simply rebalance at year end. If we rebalanced the 50:50 portfolio (figure 49) at the end of 1974, we would need to use $86,000 from fixed income to buy stocks. [ The formula is ($460,000 - $288,000)/2 ] Now $86,000, to me, is a big chunk of change. It represents two years worth of expenses. What if stocks continued to go down after we rebalanced? That would only compound the losses. So another approach would be to funnel the money gradually instead of all at once. Here’s how this could work. First, we wait for a 30% decline of our stock portfolio. That would be our trigger point and then we would start buying stocks a little bit at a time. This would be like dollar cost averaging. So for example, at the trigger point and every 3 months thereafter, we could funnel $20,000 from cash reserves into stocks until the original target allocation is again reached. This approach would achieve a lot of objectives. First, we let the diversified stock portfolio (like the Coffeehouse Portfolio) play out. In 2000-2002, it held up relatively well. If however, all areas of the market succumb to the bear, as it did in 1973-1974, we wait until the decline of the stock portfolio reaches 30%. At that point, we begin a dollar cost averaging program whereby we take small chunks from cash reserves (for example $20,000) and buy stocks on a regular interval (for example every quarter). The advantage is that even if stocks drop further, we still have some “dry powder” to buy at lower prices. Eventually, a new bull market will begin again and the shares bought low will help fuel the recovery to our overall portfolio. Conclusion This concludes my presentation of the “Retire at the Pie Shop” strategy. It incorporates the following principles: • Based on historical returns of common asset classes and inflation, use a “safe” initial withdrawal rate of 4%By following these principles, a retiree has a better chance of withdrawing inflation-adjusted annual income for the rest of his life. |
