What do people picture when they envision their retirement? Is it living in a tidy beach house where they can spend their days learning how to longboard? Perhaps they could travel the world, only stopping to savour unique cuisines while occasionally dropping in on the grandkids. While dreaming about retirement can be fun, the reality of planning it means considering several scenarios that may be challenging and unexpected. For those who are retired or retiring soon, one of those scenarios involves the real prospect of running out of money.
There are many long-standing financial models applied to retirement planning. One of these is the 4 Percent Rule. Developed by William Bengen in the mid-1990s, the 4 Percent Rule suggests that if you withdraw up to 4 percent of your nest egg during the first year of retirement, and then adjust future withdrawals according to inflation, your savings should last for at least 30 years. Given the assumption that markets will have an average return of 10 percent annually, once 4 percent of the gains are withdrawn, you should still have a 6 percent annual return for the portfolio’s compound growth. This rule of thumb has been considered a financially “safe” way to plan for retirement.
But when does the 10 minus 4 model not work?
‘Market Math’
Consider the Russell, Dow Jones or S&P indices. Broad market indices are often used to measure the success of a retirement portfolio. And while benchmark numbers can be helpful in showing market results, they don’t reveal the entire story, especially when a retiree is drawing from his or her account and is focused on long-term, financial sustainability. In fact, if investors rely too heavily on the performance numbers of broad market indices, they will always be playing a game of “Market Math” instead of building towards a strong and lasting retirement plan. To see the bigger picture in managing an investor’s portfolio, there are four underlying factors.
The Sequence Of Returns
Numbers can be misleading, especially when reviewing the sequence of returns on investments. Using Dr. Roger Ibbotson’s long-term stock market returns, since 1926 the rolling 30-year return of large cap stocks has averaged 11.2 percent. Yet, there were no instances during those 92 years where the annual return was exactly 11.2 percent. Instead, there were only six instances during that time period where large cap stocks returned between 10 percent and 12 percent in a calendar year.
A closer examination of two different points of entry for investors demonstrates why the sequence of returns matters. Per the Ibbotson data, the 30-year period beginning in 1967 saw an annualized total return of 11.9 percent. This percentage is extremely close to the 12.1 percent annualized total return for the investor who started just one year later in 1968. Assuming a 5 percent withdrawal (to account for fees and expenses) adjusted annually for inflation, the individual who retired in 1967 would have ran out of money in year 29, while the investor who began in 1968 would have had nothing left in the portfolio in year 20. Why did this one-year difference have such a huge effect? In 1967, there was a greater than 20 percent return, which the investor from 1968 would have missed. If the long-term goal is to be able to withdraw continuously for retirement income, it becomes essential to evaluate the actual dollar value of the portfolio, rather than focus on just averages and percentages.
