By: Jason Whitby, CFP, CFA, AIFA, MBA
Given the dramatic market volatility between 2000 and 2009, many retirees may wonder why they ever got involved in the markets – especially the stock market! The personal finance literature and financial advisors trumpet the need for stocks and stock mutual funds to provide for a long, comfortable retirement. But does that advice still make sense?
The answer is, as with many things in life, it depends. Read on to find out what factors determine whether you’ll have enough money to fund your retirement and whether the stock market can help you achieve this goal.
Retirement Income Variables
Multiple factors affect your retirement outcome. Principal among those factors are:
- Your withdrawal rate
- Inflation rates
- Your asset allocation
- The length of your retirement
These factors represent risks to the safety and security of your retirement portfolio and, to make things even more interesting, these factors are interdependent. For convenience, we will define “success” as maintaining the same withdrawal, adjusted for inflation, over your entire retirement.
Watch That Withdrawal Rate
It goes without saying that the less you take out of your portfolio, generally speaking, the longer it will last. The generally-accepted rule is that a 4% or lower rate of withdrawal will keep you from running out of money in retirement. Assuming a 50% stock and 50% fixed income portfolio and a 30 year retirement, a 2% annual withdrawal has a 100% probability of success. The chart below shows how the probability of success declines as the rate of withdrawal increases.
So, for a retiree with $1 million on the day of retirement who immediately starts a $20,000 or 2% annual withdrawal, there is a high likelihood that their initial retirement savings will last them for the rest of their lives. The probability of “success” drops to 88% when you increase the withdrawal to $40,000 or 4%. Increasing the withdrawal rate to $60,000, or 6%, cuts the probability of success in half. In other words, the odds of success were the same as coming up heads in a coin flip. If you need a 6% withdrawal rate to maintain your lifestyle, change your lifestyle or keep working!
Lower Inflation = Higher Probability of Success
Inflation’s impact on retirement success is fairly dramatic. We assumed a 3% average annual inflation rate in the above calculations. Since about 1940, inflation has indeed averaged 3%, so the finance and investing community blithely enter an inflation assumption of 3% into various financial planning models.
However, this almost unconscious act understates the actual volatility of the inflation rate. Did you know that the highest one-year inflation rate was recorded in 1946 at 18.2%?
In fact, over the period of 1973 through 2008, the Consumer Price Index (CPI) was above 4% approximately 40% of the time with 13.3% as the highest in 1979 and a 0.1% in 2008. The average over that period was 4.6% – one and a half times greater than the oft-used 3%. And, after multiple government bailouts and stimulus plans through 2009, the potential is high that inflation will start to rise again. In the chart below, we compare the impact of 3% and 5% inflation on the probability of success for the portfolio we discussed earlier.
As you can see, at the lower withdrawal rate, the impact of a higher inflation rate on the portfolio’s survivability is negligible; beyond that, the odds worsen fairly quickly. A retiree withdrawing 6% of his or her portfolio with inflation running around 5% annually has a one in four chance of outliving his or her assets. These are very bad odds.
Go Easy on Equities
Like inflation rates, capital market returns are also volatile. Of course, after 2008-2009, that is not exactly a revelation. The 10-year average annual return (from January 1998 through December 2008) for the S&P 500 is 1.05% with a standard deviation of 15.85. While countless studies confirm that equity exposure can help counteract the effects of inflation, the key question is: how much of your portfolio should be made up of equities?
We discussed the impact of inflation on a portfolio with 50% in equities and 50% in fixed income. What would happen to the probability of success if we took the same portfolio and reduced the equity percentage to 5%?
It is clear that the higher equity percentage in the 50/50 portfolio appears to have helped the portfolio survive, particularly with the higher withdrawal rates and higher inflation. What about a 100% equity portfolio?
Interestingly enough, the equity holdings help increase the odds of portfolio survival at a higher withdrawal rate and with higher inflation (38% versus 0%.) Of course, you’ve also got to wonder if you can stomach the high volatility of a 100% equity portfolio.
You’re probably wondering what the optimal amount of equity to have in your portfolio is, given expectations for inflation, the withdrawal rate and your risk capacity. The chart below shows the probability of success for several common portfolios under the 5% inflation rate assumption.
As you can see, portfolio survival initially improves as equities are added, but it flattens out as the proportion rises above 50%. This suggests the benefit of adding equities to combat the negative impact of inflation and a high withdrawal rate diminishes as equities are added.
Many retirees joke about having more life than money. Longevity risk is the risk that retirees will live longer than they can afford to. It is ironic that better healthcare has led to a longer, more enjoyable and more expensive retirements. This beats a short, miserable retirement any day.
For safety’s sake, most advisors advocate a life expectancy of at least 95 for planning purposes. For our analysis, we use a 30-year retirement period, but depending on when you retire that may not be long enough. Clearly, decisions that extend the probability of portfolio survival in the aforementioned cases will also increase the probability of your portfolio surviving beyond the 30-year window we chose. The one thing you can bank on is that a lot will have changed 30 years hence – hopefully for the better.
Some retirees, frustrated by the apparently increasing complexity of retirement planning, will hearken to the siren call of well-dressed salespeople selling financial products that “guarantee” income for life. Balancing the tradeoff between maximizing the probability of preserving a minimum lifestyle and maximizing the probability of lifetime wealth accumulation and consumption is tricky but not impossible and you owe it yourself to be knowledgeable.
The goal is to set a retirement plan and investment asset allocation that is closer to being right than being wrong. If there is no statistical or marginal difference, then we should be indifferent between the allocations and base our decision on personal preference.
Pick a withdrawal rate you can maintain in retirement then balance this with your inflation expectation and desire/need to take equity investment risk.