In my last article I reviewed the “rule of 25” as a means of calculating how much retirement income you will need to live a good life in retirement. It’s a handy rule, but it doesn’t take into account two important factors: inflation, which may increase the amount of retirement income you’ll need; and the state of the market when you’re ready to retire. In real life, timing is everything.
Pop quiz: how many “down” years (measured by the S&P500TM) did the U.S. stock market experience from 1982 to the end of 1999? Answer: just one—in 1991 when the market dropped a modest 3.17%. What about the heart-stopping “crash” on October 19, 1987? Despite that 25% drop on a single day (measured by many indices of the market), the year’s markets ended “up.”
If you were a little slow to realize the market had turned “bull” in the early 80s and didn’t begin investing until early 1985, and if you hadn’t time to consult your financial crystal ball about the bear market of 2000-2002, $10,000 invested in the S&P500TM at the beginning of 1985 would have grown to more than $150,000 by the end of 2007 for an annual, compound return of +12.1%. During this specific 23-year period, there were just four “down” years and 19 “up” years. Twelve of those 19 “up” returns were in the “double digits.” Two of the four “down” returns were similarly “double digits.”
Let’s make the financial statistics a little more relevant. Suppose you retired in 1985 during the early stages of a long-term bull market with $1 million of capital invested in the S&P 500TM and that you planned to pull out $75,000 a year. After eight years, your portfolio would be worth almost $2.5, more than $8.7 million on 12/31/99 and $9.2 million on 12/31/07. In fact, during the 1985-2007 period, you could have regularly pulled out $155,000 a year and still have more than $1.3 million at the end of 2007.
On the other hand, if you had retired at the beginning of 2000 with the same capital and yearly withdrawal plan, eight years later, on 12/31/07, your portfolio would be worth just $337,000. Even without the current slump in the stock market (as of July 2008), it’s virtually certain that you would outlive your money. In retrospect, to end up those eight years with your original principal intact, you could only have withdrawn $15,000 a year toward your retirement needs. Timing really is everything!
Even if we could “time” the market (and there’s substantial evidence that timing does not work), most of us envision a specific time during which we’ll transition to living off our capital rather than relying on our billable hours. If we could somehow know the market will soon peak (or trough), we might be willing to adjust our retirement date to accommodate our remarkable prescience. Most likely, however, we’re going to have to take our chances with market undulations and cycles. Therefore, we need distribution strategies that can increase the chances that we will have sufficient income throughout our retirement years.
Stratify Investments Into “Buckets”
One strategy involves first sorting out the various categories of investments in the $1 million retirement portfolio. For most, funds will span the traditional asset classes of equity and fixed investments, including cash, money market, certificates of deposit, short/medium/long-term bonds, mutual fund, ETFs, individual stocks, REITs, real estate, etc. Each of these investments has historic characteristics of risk (as measured by volatility) and return, and these critical factors tend to be inversely proportional.1
From these categories, create a series of three or more conceptual “buckets.” Bucket One holds cash and near-cash investments with durations of less than one year. Ideally, this should be planned two to three years before retiring. If necessary, existing assets can be re-positioned to assure that Bucket One holds sufficient resources to meet at least one year’s retirement income requirement, and possibly as much as three years’ income. This helps assure that volatile investments such as stocks, mutual funds, and even intermediate/long-term bonds will not have to be cashed in during market periods that depress liquidity values. Bucket One is also used—at least conceptually—to receive all sources of income including social security, other retirement income resources such as monthly annuity payments, as well as interest, dividends and gains from the other buckets.
Bucket Two holds investment categories that are typically associated with medium-term holding periods (three to five years), such as bond mutual funds and balanced mutual funds. The income this bucket produces is poured into Bucket One. Similarly, as these medium-term investments are sold and reinvested, gains will also revert to Bucket One until sufficient reserves are re-established (again, one to three years’ worth of income needs).
Bucket Three holds the longer-term investments that have the highest volatility of all portfolio assets, but also have the highest potential for long-term gains. Dividends and gains will flow back to Bucket One, once again subject to the reserve needs of that bucket.
Additional buckets can be used according to the type and diversity of portfolio investments. As you can see, this approach does not dictate the nature of your investments; that depends on your risk tolerance and preference to manage (or not manage) a portfolio. Rather, the “bucket” strategy is about stratifying your investments along the risk/reward continuum, allowing you to consume income from those investments with the least likelihood to lose principal while giving higher risk/higher return investments sufficient time to perform on their return expectation. In essence, the bucket method describes a process for organizing your investments for maximum lifetime sufficiency, whatever those investments might be. Note that the need for ongoing investment management and occasional reallocation still applies.
Assess Your Risk Tolerance
A second strategy involves a little less discipline and organizational skill. Recognizing that a typical 65-year old has a 20-year life expectancy, you would take 80-85% of your current $1 million portfolio and invest according to your risk tolerance for maximum income, living on investment return and principal over those 20 years. The 15-20% portion not already allocated is specifically invested with a 20-year time horizon, presumably with greater risk tolerance than that which will be applied to the larger segment of the $1 million portfolio. While most of us would not employ an all-equity allocation to our entire portfolio, it’s entirely possible that such a strategy could be reasonably applied to this 15-20% segment invested for the long-term.
At age 85, only two conditions prevail: either you succumbed to life expectancy statistics, or you survived them. If you are still alive, you have—by the formula suggested below—completely exhausted your 20-year income portfolio and now look to your “I beat my life expectancy” portfolio to take care of your income needs for the rest of your life. For example, a $150,000 initial allocation of the original $1 million could grow to $400,000 at an average 5% return; grow to $700,000 at an average 8% return; and grow to $1 million at an average 10% return. If then converted to an immediate annuity at age 85, the monthly income could range from $5,300/month based on $400,000 to as much as $13,250/month based on $1 million on a single 85 year old male. A joint annuity (with the monthly payment for as long as either spouse is alive) for the lives of spouses (both age 85) range from $3,950 based on $400,000 and $9,875 based on $1 million.[2]
As for the first 20 years in which you are distributing income and principal, here’s the recommended formula, assuming a constant 5% return:
Year 1: distribute 1/20 of the initial value (1/20 of $850,000 = $42,500)
Year 2: distribute 1/19 of remaining value (1/19 of $847,875 = $44,625)
Year 3: distribute 1/18 of remaining value (1/18 of $843,413 = $46,856)
etc. until…
Year 20: distribute remaining value (1/1 of $107,395 = $107,395)
If your long-term investment skill (and a cooperative market) results in an average 8% return, the annual income ranges from the same initial $42,500 up to a 20th year portfolio liquidation value of $183,417. Needless to say, however, the market does not increase in smooth increments of return! Volatility will have a significant effect on each year’s balance for which the applicable distribution percentage will be paid. Thus, average returns are used here to illustrate the methodology, but investment professionals should be consulted for “volatility studies” that can suggest probabilities of success based on different investment strategies within the 20-year timeframe.
Que Sera, Sera?
These two distribution models do not take into account considerations for income taxes, or the possibility that you may have testamentary intentions that work against the concept of “spending” principal.
But they do exemplify the types of strategies that can help us have sufficient income for the much longer life expectancies than, on average, our parents experienced. Unless we’re fortunate enough to start with a substantial amount of retirement capital relative to our income needs, those needs cannot be satisfied with conventional thinking such as “buy bonds and live off the interest.” Similarly, “Whatever will be, will be” is not an investment strategy. We will need to more actively explore retirement solutions that can produce adequate income for the 30 or 40 years of thriving through and beyond mid-life to which we’re all entitled.
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FOOTNOTES
1. Money market accounts and short-term bonds tend to assure safety of principal in exchange for nominally low rates of return. The July 1, 2008 90-day T-Bill yield of ~1.8% can today be considered a “safe” rate of return with no risk and very short duration. To achieve a rate of return much higher than this, a certain amount of risk (either volatility and/or liquidity risk or penalty-for-early-withdrawal risk) will need to be taken. While risk is a key factor in our investment decisions, exposure to risk is directly proportional to time: the quicker you need your money back, the greater the risk you won’t achieve your objective. On the other hand, it is interesting to note that no rolling 20-year period since 1926 (i.e. 1926-1945, 1927-1946 etc) has produced a negative return when underlying investments were in the broad equity market.
2. These suggested immediate annuity monthly income value are calculated by insurers based on mortality tables in effect in 2008 and are not necessarily indicative of rates that might prevail 20 years from now.
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