A simple question but as it is with everything to do with money, the answer can get complicated very quickly. Let’s start with the easy math. If your household can comfortably get by on $50,000 a year in today’s dollars, to afford that same standard of living 20 years from now will require about $100,000 (blame it on that surreptitious tax called inflation). With a need for $100,000 a year and assuming a relatively safe 4% withdrawal rate from a portfolio growing at 7% requires a $2.5 million of liquid net worth when you retire to enable you to never run out of money and still have some leftover to bequeath it to your heirs.
To end up with $2.5 million, 20 years from now means that you need to have about HALF a million bucks (YIKES!) stashed away today. Don’t panic yet because that assumes you invest now and never add anything to that kitty for the next 20 years. Maxing out your retirement accounts at work annually would bring the required savings amount to about $200,000. And if you don’t have that tidy sum stashed away now only means one of three things; delaying that eventual decumulation stage, increasing your savings rate or plan to not leave anything behind. There is no other option.
But let’s assume that you have that $200,000 set aside with plans to add about $20,000 each year through your workplace retirement plan. You are all set then, right? Well here it is when it starts to get a little tricky. That 4% systematic withdrawal rate assumes a deterministic and static annual return of 7% each and every year. The US markets have averaged about 10% annually for more than a century but that does not mean you get 10% each and every year. Some years the market would retract significantly followed by big rallies in other years to eventually deliver that 10% on average. If withdrawals from your portfolio start during one of those typical multi-year market declines, you could run out of money very, very quickly. What is not typically assumed by portfolio managers and investment advisors is understanding and planning for the sequence of returns, an extremely critical element to make a portfolio last in perpetuity and that is what this excellent paper titled “Retirement Ruin and the Sequencing of Returns” by Moshe A. Milevsky highlights. Retirement ruin is the age at which you basically run out of money. The paper assumes a hypothetical investor with $100,000 at age 65 and withdrawing 9% each year (an extremely high withdrawal rate used for illustration purposes only). The paper also assumes that the cycle of the sequence of returns repeat every three years. The table below summarizes the age points when this hypothetical retiree will run out of money.
As is evident, the order of returns can make a huge difference as to how long can your savings last. Imagine having your money lasting 14 more years from the worst case sequence of returns to the best case for the same exact amount of savings. This also directly ties into the need to optimize portfolio volatility and that is why our portfolios are designed to not only maximize returns but to maximize volatility-adjusted returns.
So the next time you think you are on track for retirement, think again and plan for the worst-case sequence of returns.
Image credit – Kevin Marsh, Flickr