It’s a real shock to learn how little you can withdraw from your savings every year after you retire without running out of money.
A healthy 65 year-old can now expect to live into his or her 80s or 90s. In other words, your savings must last for 20 to 30 years. Even if you invest wisely and limit your annual withdrawals, that takes a huge pile of money.
Very, very few people can save enough to live on their savings alone for two or three decades. Fortunately, few of us have to. On average, Americans aged 65 and older receive 40% of their income from Social Security; 25% from wages and self-employment income; 20% from retirement accounts and pensions; and about 13% from non-retirement investments.
So how much can you take from your savings every year?
Studies using past financial data show a retiree must limit annual withdrawals to an inflation-adjusted 4% to 5% of his portfolio’s balance at the start of retirement if he wants to be reasonably certain his portfolio will last as long as he does -- i.e., a portfolio worth $1 million on the day you retire can probably produce a constant $40,000 to $50,000 a year until you die. That assumes at least 50% of the portfolio is invested in stocks. It also assumes you don't count on leaving anything for your heirs.
This stark conclusion flies in the face of longstanding conventional assumptions. The typical response is: Why can’t I earn a 10% average annual return on my investments, withdraw 6% of my savings each year, and leave my survivors a nice legacy?
We've all seen handsome illustrations that show big stocks and small stocks have respectively earned 10% and 12% average annual returns since 1925. Unfortunately, as William J. Bernstein explains in The Investor's Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between-- a brilliant and wonderfully readable book -- you cannot have those returns. In real life, no investor has ever had those returns: They exclude investment fees, transaction costs, and taxes. They also assume that all gains were reinvested for 80-plus years.
Last and most importantly, writes Bernstein, the historic numbers reflect a reality that no longer exists: "We cannot go all the way back to the end of 1925, when U.S. stocks yielded 5 percent." The current dividend yield on the U.S. stock market is about 1.7%. Why is this important? Because almost half of the historic return on stocks comes from their reinvested dividend yield, not from rising stock prices.
But even if you could earn a 10% average annual return, there is a huge difference between an average annual return over a 20 year period, and actual returns in each of those 20 years. The average airbrushes out all the annual volatility. In bad years your investments will earn less than the longterm average -- and in awful years, they'll lose money. Meanwhile, inflation will steadily erode the purchasing power of the dollars you withdraw to pay your annual expenses. In two decades, a modest 3% annual inflation rate cuts the value of a dollar in half.
The upshot is that if you want your money to last as long as you do, your annual spending rate has to be well below your optimal longterm average annual investment return.
An analysis of 75 years of market data by Bill Bengen, a California fee-only financial planner -- one of many studies to reach similar conclusions -- found that a retiree with a 30 year horizon couldn’t safely withdraw more than about 4% of his initial portfolio every year, plus annual inflation. (In a future post, I'll address whether you can boost your spending rate if you have a shorter horizon.)
The Bengen studies and others are based on the past. They can design hypothetical portfolios and trace what would have happened to them using real market returns, inflation and tax rates. Obviously, predicting the future is a different matter. But forward-looking numbers-crunchers using ‘Monte Carlo’ simulation software to compare the impact of hundreds of possible future market scenarios on multiple combinations of assets have reached the same conclusion: Your savings are unlikely to last for two or three decades unless you start with a huge portfolio or adopt a very modest spending annual spending rate.
If you want to run your own portfolio through such calculations, your best recourse is to go to a fee-only financial planner – i.e., someone who charges for advice, but doesn’t earn money selling investments – whose software program lets you put in your own assumptions. With online calculators, you must accept built-in assumptions, which aren't always revealed and are often over-optimistic.
Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are only addressed online.
(c) Lynn Brenner, All Rights Reserved