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This topic is one some people might want to avoid: the unpleasant possibility that a retired investor could someday run out of money.
It’s also about market timing. The conventional wisdom on Wall Street and in the financial media is that anybody who practices or tries market timing is a fool. But frankly I don’t think most of the people who make that assertion know what they are talking about.
People often tell me that there’s no proof that timing works. Of course there can be no proof that something will work in the future. But what I’m about to show you is overwhelming evidence that timing can make a tremendous difference. In many cases, timing will prevent retirees from running out of money.
For this study, I chose a timing system that anybody can use without professional help, even without a computer. It’s not proprietary, and everything about it is fully disclosed.
We applied this timing system, which is described here, to a common problem faced by retirees: How do you assure yourself that you’ll have enough to live on, that your money won’t run out – and that you’ll have something left over to leave to your children when you’re gone.
We have looked at several withdrawal plans designed to cope in various ways with three important variables that will determine whether you outlive your money or your money outlives you. These three unknowns are your future living expenses, your life expectancy and your future investment returns.
We have the benefit of a new look at the subject from one of our readers, Henry “Bud” Hebeler, retired president of the Boeing Aerospace Company and a tireless advocate of retirees. Bud runs a Web site ( www.analyzenow.com) with a lot of interesting, useful resources. And he has created software that’s used by many financial planners.
Bud made a series of involved calculations on the assumption that a retiree needs to have his or her resources last for 40 years. This is not a far-fetched assumption, with more and more people hoping to retire at age 55.
Bud also assumed that a retiree needs income that will grow to match the cost of living.
These are heavy demands to place on any portfolio, but they are based on two facts of life: You could live for a long time, and you’re likely to be hurt by even mild inflation unless your income goes up.
Bud started his calculations on the premise of a 60-year-old with $100,000 invested, a 40-year life span and the need for annual income of $7,000, adjusted each year for actual inflation. He also deducted 0.5 percent a year to represent investment expenses.
Bud compared three asset allocation assumptions: all stocks, measured by the Standard & Poor’s 500 Index; all bonds, measured by long-term corporate bond averages; and what he calls a “classic” mix of the two.
This classic mix starts with a 50/50 split, but only for the first year of retirement. Bud assumed the portfolio was rebalanced every year with one percentage point less in stocks: 49 percent the second year, 48 percent the third year, etc., so that bond funds play a gradually larger role as the retiree grew older and presumably more conservative.
For each of these allocations, Bud used actual historical investment returns and inflation figures to calculate the results of retiring in 1927, starting with $100,000 and taking annual withdrawals of $7,000 adjusted each year for inflation. He repeated those calculations 49 more times for later retirees starting in each year through 1976.
In each case, Bud was seeking a simple yes-or-no answer for this question: Would the initial $100,000 have lasted for 40 years?
His conclusion: Most people underestimate the risk that they might exhaust their savings. For example:
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None of the all-bond or classic-mix portfolios held up longer than 30 years. But in 17 cases (out of a total of 50), all-stock portfolios survived more than 40 years.
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Depending on when they retired, from 1927 through 1976, retirees who followed Bud’s withdrawal formula had only a 50 percent chance of having their money last for 24 years if they invested 100 percent in stocks.
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Those who invested in the “classic mix” of stocks and bonds had only a 50 percent chance of their money lasting for 18 years. For all-bond investors, it was 13 years.
The results were very different, depending on the year an investor started retirement, because actual investment returns and inflation varied widely during the 74 years in this study. If you retired just before a major downturn in the market, you could quickly suffer losses that were unrecoverable under the withdrawal assumptions of this study.
For instance, investors who retired in 1973 following this plan ran out of money in either nine years (all-stock portfolio) or 10 years (all-bonds or the classic mix).
Worse, investors have no way to know in advance whether they are retiring at a particularly advantageous time (for instance any year from 1947 through 1954 for all-stock investors) or a bad time (for instance any year from 1959 through 1973).
This is not good news for retirees. But there are a few fairly obvious ways to increase your chances of outliving your money.
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Retire later. This could also be expressed as “work longer.” It helps you two ways: You have more time to build up savings and you have less time to deplete them.
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Reduce your required standard of living. If you start with a withdrawal of 6 percent instead of 7 percent, you’ll deplete your savings less rapidly. A 5 percent withdrawal rate is even more likely to last 40 years.
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Don’t insist on withdrawing enough to keep up with inflation. This is a tricky prescription, because inflation is an insidious force that slowly but relentlessly robs you of your purchasing power. However, over a presumed 40-year retirement, not all your living costs will go up as fast as the cost of living. By the time you reach your 80s, it’s unlikely you’ll be spending as much of your income on clothing, houses, cars and appliances as you did when you were younger. Thus your real needs will probably go up less rapidly than inflation.
I’m pleased to say that I’ve identified another way you can greatly decrease your odds of running out of money: Use market timing.
I’m not talking about paying a professional money manager to time your investments. I’m talking about a simple timing system that anyone can apply with only a hand calculator.
I asked my staff to replicate Bud’s study with one important modification. Instead of investing in the Standard & Poor’s 500 Index on a buy-and-hold basis, I assumed a new retiree managed the index using a simple 200-day moving average. (Click here for an article that tells how to compute this.)
Because of the limitations of our data, we could go back only to 1942 for this. But that still gave us 20 periods that lasted the full 40 years plus 15 that started too recently to give us 40 years. (However, in all but one of the shorter periods, we saw the final result.)
In total, we had 35 periods in which to compare the results of the Standard & Poor’s 500 Index on a buy-and-hold basis against our simple do-it-yourself timing system.
You’ll find the results in the table. Here are some highlights:
When we used a withdrawal rate of 7 percent adjusted for actual inflation, timing produced a better result than buy-and-hold in 33 of the 35 periods. The exceptions were a 40-year retirement from 1947 through 1986, in which the buy-and-hold portfolio wound up with slightly more money than the timed portfolio, and the 26-year period from 1975 through 2000. In every other case, timing either lasted longer or produced a higher ending value than buy-and-hold.
There were 12 periods in which both portfolios survived 40 years. The final value of those periods, the amount which a retiree presumably could leave to the next generation, averaged $3.2 million for timing and $1.6 million for buy-and-hold.
In the 17 periods in which they both ran out of money, timed portfolios lasted 23 years on average, vs. 16 years for buy-and-hold portfolios. In three periods, timing survived 40 years but buy-and-hold was exhausted long before that.
In only one period, 1975 through 2000, was the final outcome still unknown, with four years to go.
In the end, we concluded that it's very risky to recommend a combination of 7 percent withdrawals and adjustments for actual inflation.
We next looked at the same combinations, only with a 6 percent withdrawal rate adjusted for actual inflation.
Again we found that the timed portfolio did better in 33 of 35 periods. Of the 20 periods that lasted for 40 years, the timed portfolio survived 100 percent of the time, while the buy-and-hold portfolio survived in only 15 periods.
In the 15 periods in which both approaches survived, buy-and-hold left retirees with an average of $1.9 million after 40 years, while timing left them with an average of $3.8 million.
In the 11 periods in which both timing and buy-and-hold ran out of money (this included most of the periods that started after 1960), buy-and-hold lasted an average of 12 years, while timing lasted an average of 24 years.
Our conclusion: If you’re going to take out 6 percent, adjusted for real inflation, this simple timing system was far superior to buying and holding. But in 11 periods, timing still couldn’t avoid exhausting a portfolio.
So we took one more step toward being conservative and assumed a 5 percent withdrawal rate, adjusted for actual inflation. Many academic studies of portfolios have concluded that 5 percent is a “safe” rate to draw from a retirement portfolio. But that wasn’t true if retirees used buy-and-hold and the withdrawals were adjusted for inflation.
Just as before, we found only one period out of 35 in which the buy-and-hold portfolio did better than the timed one. Timing survived every period that lasted 40 years. Buy-and-hold ran out of money in four of those periods.
In the 40-year periods in which it survived, buy-and-hold left retirees with an average of $2.5 million after 40 years. In the 40-year periods in which timing survived, it left an average of $4.3 million.
We realize this study does not lead to any prescribed course of action that’s guaranteed to make retirees happy and wealthy. Life simply is not that simple. But here are a few useful conclusions to come out of this work:
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Whatever withdrawal rate you choose, market timing is likely to make your money last longer than a simple buy-and-hold approach.
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Timing is also likely to allow you to leave a larger legacy to your children or your favorite charities.
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Timing’s lower volatility is likely to let you live through your retirement years with less anxiety.
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With timing, you’ll be less likely to have to downgrade your lifestyle.
Here are a few final thoughts.
Most retirees and soon-to-be-retirees that we know have four big financial concerns. They want an adequate standard of living. They don’t want to run out of money. They don’t want inflation to rob them of their purchasing power. And they want to have something left at the end for a legacy to their children, their favorite charities or other heirs.
I’m convinced that market timing will help with each of those objectives.
But unfortunately, you will never find a guaranteed way to accomplish them all. These four objectives sometimes compete with each other. You can leave a legacy if you live like a miser. You can live high on the hog for awhile if you are willing to take the risk of outliving your money. You can start out with an ambitious rate of withdrawal if you aren’t worried about inflation.
But unless you have a vast amount of money, you’ll probably have to juggle these competing goals. That’s just the way it is.
I think you’re more likely to be satisfied and happy in retirement if you accept the fact that life is uncertain by its very nature.
Here’s my parting advice: Whether or not you use market timing, do your best to take the point of view that no matter how well you set up your retirement, somewhere along the way you may have to change your plans to adapt to circumstances that you can neither predict nor control.
That’s a youthful attitude, and I recommend it to you.
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