Will Your Retirement Income Crash?

If you are like most people I know, there is one question uppermost in your mind when you think about your retirement; will I have enough money to last? Of course you have some control over some of the forces that shape the answer (how much you spend, earn, save and how you invest). But you don’t have a lot of control over other important components; how long you will live and how much your investments will earn.

Because the answers to those two questions are impossible to predict, you can’t know for certain if your retirement plan will work or not. And I have more bad news. Even after you finish reading this post, you still won’t know how long you will live or what your investments will earn. 😳 But all is not lost. According to a newly released in-depth study, it’s easy to know which investments minimize your odds of running out of money. Rejoice.

The Study

As reported by Financial Planning Magazine, Craig L. Israelsen, Ph.D. created a time machine of sorts. He went back in history and followed a hypothetical investor. He looked at how well that investor did making annual withdrawals using 3 different portfolios over very long periods of time. He wanted to see if they ran out of money or not based on A) the withdrawal rate they used and B) the type of portfolio they selected.

The first portfolio he looked at consisted of 100% U.S. bonds. The second was the “Your Age in Bonds” portfolio.

(Some people feel that as you age you should invest more conservatively and put more in bonds and less in equities.  So if you use this formula and you are 35 years old today, you’d have 35% of your money in bond funds and 65% in equities (he used the S&P 500 index fund for the equity portion of the portfolio). When you turn 36, you rebalance your portfolio and put 36% of the account in bonds while keeping 64% in equities. You continue to rebalance and shift to bonds as you get older each year under this approach. When you reach 100 years of age, you have all your money in bonds. Simple enough.)

The third portfolio was made up of 25% S&P 500, 25% small cap, 25% U.S. bonds and 25% U.S. 90 day Treasury bills. This hypothetical portfolio was rebalanced each year to maintain this allocation.

Dr. “I” looked at each of these portfolios and how they fared over 35 years assuming an investor withdrew 3%, 4% or 5% each year. And in order to combat inflation, the investor in this hypothetical study increased her withdrawal by 3% each year. So, if you have a $250,000 portfolio and you are on the 3% withdrawal plan, you take out $7500 the first year. In the second year, your withdrawal would be $7725 ($7500 + 3%) and so on.

Basically, he wanted to see if a 65 year old could use one of these portfolios to create income, adjust for inflation and not run out of money by age 100.
The good Doctor analyzed what happened over 54 rolling 35-year periods. Let me explain what that means. Israelsen took one 35 year period of 1926 to 1960, another from 1927 to 1961, and another from 1928 to 1962, all the way through the last period of 1979 to 2013.

All together, the study included 54 of these 35 year rolling periods. The Dr. calculated the year-by-year values of each portfolio with actual historical returns based on how each portfolio was invested and whether the investor took a 3%, 4% or 5% annual withdrawal as I said.

Exhibit 1 (above)  shows the results assuming a 3% withdrawal rate. If you examine the 100% bond portfolio, you can see that people using that portfolio didn’t run out of money 69% of the time. It also shows that if the investor didn’t run out of money, he or she had $821,607 on average at age 100 – not bad. Of course 31% of the time this ultra-conservative investor blew through their portfolio and had to go to work at Flippy Burger or move in with the kids – neither an attractive outcome.

Exhibit 2 (above) shows the historical results using the same portfolios but with a 4% withdrawal rate. And Exhibit 3 (below) uses a 5% withdrawal rate.

Take Aways

You can see that as the withdrawal rates increase the risk of running out of money goes up. Nothing earth-shattering there. Look at the 25-25-25-25 portfolio. With a 3% withdrawal rate (exhibit 1) investors never ran out of money. But when they kicked up the withdrawals to 5%, only 89% of the investors made it. The other 11% went through all their money before reaching age 100.

And you can see that as you add more equity to the mix, your portfolio survivability increases. This was also expected. But there are some other less-obvious conclusions that bear discussion too:

1. If investors start their withdrawals during a very bad period in the market and the investor withdrawals 4% or more, it has a huge impact on the results. That’s because if the capital gets chewed up right from the start, the account may not be large enough to generate the money needed to make the withdrawals in the future.

Assume you have $100,000 and plan to withdraw $4000 in year one. That’s a 4% withdrawal rate. But what happens if the market gets whacked by a financial tsunami and the account drops to $50,000 in year one? Now your $4000 represents an 8% withdrawal rate and that’s way too much. At that rate, the investor has a very low chance of seeing their money last.

While there are solutions for this problem, the study didn’t address alternative withdrawal options for bear markets. Instead of changing the withdrawal rate in response to bad markets, Dr. Israelsen suggests that retirees who depend on their assets for income mitigate risk by putting at least a portion of their money in bonds. That’s because the worst one-year loss for bonds was -2.9% (in 1994). The worst one-year loss for stocks was 43.3% in 1929. You can see how bonds might shield investors in certain circumstances.

2. Even though stocks did really well over long periods, they lost money 27% of the time or almost once every 3 years. That’s why emotions can sometimes override intellect. Fear can take over and force investors to sell at the worst possible time. That’s why it’s important to be ever mindful of your emotions and make sure they don’t force their way into the driver’s seat of your retirement plan.

3. When interest rates were really low (1940 through 1960) the all-bond portfolio did especially poorly. With current rates also low, it’s probably smart not to overdo it with bonds right now.

4. While the averages favor equity, it’s important to not lose sight of the risks. There were periods during which investors ran out of money using a 4% or 5% withdrawal rate too. In other words, no guarantees Pilgrm.

5. This study did not consider an all-equity portfolio and I think that’s a shame. It’s not that I recommend an all-equity portfolio for everyone; I don’t. But it would have been interesting to compare the all-equity account to the other 3. I say that because even the 3rd portfolio – the one with 25% of the money in 4 different assets – only had 50% of the money in equity.

Bottom line? It may be uncomfortable at times, but if you want to minimize the chances of crashing during retirement, equity should be something you consider. And regardless of how you invest, keeping up on studies like these helps you remain unemotional when it comes to investing. At least that’s my take.
Do the results of this study make you think about investing differently? How?