Q: You’ve written about studies showing you should use a 4% annual spending rate if you need your money to last for up to 30 years. Can you use a higher spending rate if you only have a 15 to 20 year horizon? --DA via email
A: Financial professionals say you’re probably safe using a 5% annual spending rate if you have a 15 to 20 year horizon; but they warn that if you exceed a 6% rate, you run a serious risk of outliving your savings.
In other words, cutting your horizon from 30 years to 15 years doesn't mean you can prudently double your annual spending rate.
Why must you be so cautious? A major but little-understood reason is that all retirees are exposed to what I think of as the Terrible Timing risk.
Here’s what I mean:
Even in a 15 year period, there’s a very good chance that you'll live through more than one bear market. (In the last 15 years, we have experienced two horrific bear markets: 2000-2002 and 2008-2009.)
The question is, when will these bear markets occur?
To explain why this matters so much, Parsipanny NJ financial adviser Mark Cortazzo tells a story about three imaginary brothers whom we’ll call Andrew, Bob, and Charlie.
Each brother retires with a $1 million nest egg invested in Vanguard’s S&P 500 Index Fund. Each brother uses a 6% annual spending rate, withdrawing $5,000 a month ($60,000 a year) from his portfolio. (To keep things simple, there are no inflation adjustments in their withdrawals.)
Andrew retires on January 1, 1997. Bob retires on January 1, 2000. And Charlie retires on January 1, 2003.
Their starting balances, investments, and withdrawal rates are identical -- but by July 2010 there’s a dramatic difference in their portfolio balances.
Andrew still has almost $1 million; his balance is $999,310. Charlie has $1,008,561. And Bob -- who had the bad luck to retire just as the stock market tanked -- has only $261,884 left.
The moral: If you happen to retire at the start of a bear market, your money won't last nearly as long as it will if you retire at the start of a bull market.
So what can you do about this?
You can't control future market cycles, so there's no sense in wasting sleep about them. Instead, focus on what you can control:
Trim your annual living expenses (and that includes paying down credit card debt and minimizing investment-related fees).
Maintain a well-diversified portfolio to reduce the risk that all your investments are hammered at the same time.
Maximize alternative sources of retirement income (like Social Security and part-time earnings).
And spend your nest egg at a conservative annual rate!
Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are only addressed online.
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