If you were going to climb a mountain would you hire a guide? What if the guide told you he was confident he could get you up the mountain but wasn’t sure he could get you back down? My three sons are Eagle Scouts so I have logged a few hiking miles. Most think the objective in hiking is to reach the top. Is that what you would say? If so, you would be mistaken. The real objective is to get back down the mountain safely.
This analogy holds true in our financial lives as well. For years we accumulate assets through the process of savings and investments in the hopes that someday we can retire. This is our trek up the mountain. But when we retire our money has to start producing an income for our remaining years. This transition occurs when we reach the summit. Our journey down the mountain begins the process of distributing our assets in the form of a retirement income stream.
Unfortunately, most financial advisors focus solely on the trek up the mountain (accumulation) with no understanding or consideration for the decent (distribution), meaning how to effectively convert retirement assets into a guaranteed stream of retirement income.
Understanding how retirement assets react in a fluctuating interest rate environment when money is being withdrawn for income is essential to getting down the retirement mountain safely! If not, retirees run the risk of running out of money. The primary problem becomes the issue of withdrawal rate risk and sequencing of returns.
The fallacy is assuming we live in a constant, linear interest rate environment. We do not! Consider the following: the best 30-year period of the S&P 500 was from 1970 to 1999. The average rate of return for this period was 14.81%. A person retiring in 1999 might conclude a safe retirement withdrawal of 10%. This would seem possible, as a supposed $1.0M asset would grow to $14.9M after 30 years, even after taking out 10% of the balance each year. Wow! Obviously, this looks great! But wait, we don’t live in a linear interest rate environment. No one gets average rates of return; we get actual rates of return!
To understand further, if actual S&P 500 rates of return were applied, the retiree would have run out of money in year 14! So, what happened? Blame it on pesky fluctuating interest rates. From 1970 to 1984 there were 10 up years but 4 down years. Retirees over the past 15 years have faced similar sequencing of return troubles with the dot.com bust and the 2008 banking failure caused by the housing crisis.
The question then becomes, “What percent of my portfolio can I safely withdraw to insure I don’t run out of money?” Obviously, 10% did not work in our example. So what is the correct answer (8%, 6%, 4%)? This question is the subject of lengthy research, analysis and debate, especially given our historic low interest rate environment.
Consider a review of the following well respected source: Investing Your Lump Sum at Retirement, by David F. Babbel (professor at The Wharton School, University of Pennsylvania) and Craig B. Merrill (professor at The Marriott School of Management, Brigham Young University) both are Fellows of the Wharton Financial Institutions Center.
In addition, MorningStar a leading Wall Street research firm conducted a recent study titled, Low Bond Yield and Safe Portfolio Withdrawal Rates. This paper was written by David Blanchett, CFA, CFP, MorningStar Investment Management, Michael Finke, Phd, CFP, Professor of the Department of Financial Planning at Texas Tech University and Wade D. Pfau, CFA and Professor of Retirement Income at the American College. Finally, read a Wall Street Journal article by Kelly Greene entitled, “Say Goodbye to the 4% Rule.”
What were their findings? Conventional wisdom has dictated a 4% withdrawal rate, but current research now suggests 2.8% to 3.5%. This is also supported by dozens of Monte Carlo simulations, which is a software program used in the financial planning industry to calculate historic probabilities of running out of money years into retirement based on various withdrawal rates chosen.
Since we don’t want to run out of money in retirement, then we should all register a sigh of relief with their withdrawal rate conclusions. But, not so fast! Although, the correct withdrawal rate solves one problem, it creates another.
A 3.5% income rate is often not a feasible solution as it will be difficult to build sufficient assets to enjoy a “happily ever after” retirement. For example, our $1.0M nest egg illustration only yields a paltry $35,000 of annual retirement income! This income is woefully short of most expectations.
To make matters worse, Rodney Brooks in a USA Today article dated 2/13/2014 stated that Fidelity Investments, the nation’s largest 401(k) provider, noted that the average 401(k) balance for pre-retirees 55 and older was $165,200. “Houston, we have a problem!”
In reality, 7-13% income rates will likely be needed to achieve adequate income based on attainable retirement asset amounts. But how can this be done without running out of money? There is a viable solution to getting down the retirement mountain safely. Stay tuned!