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Withdrawals in retirement: taking less can give you more |
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June 12, 2006 |
Most investment articles focus on the accumulation stage of investing -- how to acquire a retirement nest egg and make it grow. In the following article, Paul Merriman discusses some vital choices retirees make, either by design or by default, when they enter the equally important withdrawal stage. More sometimes turns into less. And less can turn into more.
by Paul Merriman
Editor and Publisher
You may have saved for many years and invested your money carefully. But when the money has to start flowing in the reverse direction – when your portfolio has to start paying you – suddenly you’re face-to-face with a whole new set of challenging choices.
Most articles and advertisements focus on accumulating money over a lifetime in search of a comfortable retirement. Anybody who has even casually flipped through the pages of financial magazines has seen the charts with upward-sloping lines dramatically depicting a growing pool of savings from successful investments.
Too often overlooked is the equally crucial period of most people’s investing lives in which money is being withdrawn. The details of how your portfolio pays you can easily make the difference between having a secure retirement and running out of money.
That’s what this article is about, and I think it’s so important that it should be taught to younger people who are trying to determine how much they must save to afford to retire. There is really no way to know how much money you’ll need for retirement unless you know how much money you’re going to take out – and how you are going to take it out – when you’re retired.
I want to show you five tables of numbers that we use when we work with clients who are retired or about to retire. We also use these tables in our popular workshop, “Live It Up Without Outliving Your Money.”
When you reach retirement, four major decisions will determine the bulk of your financial future.
• How will you invest your money?
• How much risk will you take?
• How much do you need or want from your portfolio every year?
• Do you need a fixed amount, adjusted for inflation, or can you tolerate a variable withdrawal schedule?
You’ll find our recommended answer to the first question, and the reasons for those recommendations, in an article available online at FundAdvice.com called “The ultimate buy-and-hold strategy.” That tells you how to find the funds that I believe are most likely to give you the best long-term returns.
The second question hinges on how much of your portfolio should be in equities and how much in fixed-income. I have dealt with this topic extensively in an article called “Fine-tuning your asset allocation,” an article that includes a large table which you’ll find here as Table 1.
For a larger version of Table 1, click HERE.
If you haven’t read the “fine-tuning” article, I highly recommend it as well as one called “Risk vs. reward: What’s best for you,” which is also based on Table 1.
I’d like to call your attention to something very interesting in Table 1, something that could easily be overlooked. The 50 percent equity column, representing a portfolio half in fixed-income with the equities split evenly between U.S. and international funds, achieved an annual return from 1970 through 2005 of 11 percent.
That is virtually identical to the return of the Standard & Poor's 500 Index. Yet the 50/50 portfolio entailed less than half the risk of the widely followed index.
The third and fourth questions I posed earlier are the main focus of this article. Ultimately, you are the only one who can answer those questions, and you may need some help from a financial advisor to come to the best answers for you.
AN INTERESTING DILEMMA
The next four tables are worth study and discussion with your spouse or partner, if you have one, and with your financial advisor.
Many pre-retirees never give much thought to how much they’ll take out of their portfolio each year. But the question presents an interesting dilemma.
• If you take out more money early in retirement, you can enjoy more of the things you have looked forward to while you’re “still young” and can participate more fully in life. However, if you take out too much and you live a long life, this can leave you with less money – or even no money – later in life.
• If on the other hand you take out less money early in retirement, you’ll have more to use later if you live long enough and are healthy enough to enjoy it. In the meantime, taking out less could mean you may continue to postpone some of the things you have saved for and looked forward to.
We’ll come back to this basic dilemma again.
Tables 2 through 5 give you a taste of what would have happened under four scenarios to somebody who retired at the start of 1970 with $1 million. In each case we assume the new retiree takes a distribution of either $40,000 or $60,000 at the start of 1970; subsequent withdrawals occur at the start of every following year.
Tables 2 and 3 deal with “fixed” withdrawal rates. Each annual withdrawal (or paycheck, if you will) is determined in advance and adjusted to account for the previous year’s inflation. In the tables, we assume 3.5 percent inflation. This lets you know in advance exactly how much (in inflation-adjusted dollars) you will have every year, and you can plan your life accordingly.
For a larger version of Table 2, click HERE.
For a larger version of Table 3, click HERE.
Fixed withdrawals may be necessary for the person who has saved barely enough for retirement and who does not have the ability to withstand a drop in income. As long as the portfolio doesn’t run out of money, fixed withdrawals assure a basic retirement income that can be counted on. While these withdrawals are responsive to inflation, they don’t adjust to the market. They can become larger than a portfolio can afford; ultimately, they can push the portfolio to the brink of running out of money.
Tables 4 and 5 are based on “flexible” withdrawal rates. Each annual withdrawal is computed as a percentage (either 4 percent or 6 percent) of the portfolio’s value at the end of the preceding year. After good investment years, the withdrawal goes up. After bad years, the withdrawal goes down.
For a larger version of Table 4, click HERE.
For a larger version of Table 5, click HERE.
Flexible withdrawals represent a financial luxury for people who have saved more than enough to meet their basic needs. These people must be (and presumably are) able to tolerate lower withdrawals after unfavorable years in the markets. In return, they get the promise of bigger payoffs after especially good years.
In the short term, a fixed-distribution plan is oblivious to what happens in the market. However, in a prolonged unfavorable market, fixed distributions can become impossible to sustain.
Variable distributions, on the other hand, are always responsive to what’s happening in the market. That makes them much more sustainable.
TWO BIG MISTAKES
There are lots of mistakes investors can make in retirement, but two big ones loom over all the others. The first is retiring with insufficient savings. This can lead to crippling the portfolio by taking out too much money.
The second mistake is investing without proper diversification.
Notice the year 1995, for example, in Table 2, representing what happened to somebody investing only in the S&P 500 Index and taking what we consider aggressive withdrawals of 6 percent. The scheduled withdrawal of $141,795 at the start of 1995 would be nearly 17 percent of the portfolio’s value ($843,127) at the end of 1994, just before the money was taken out.
No portfolio can stand up for long at that rate, and even with the great bull market of the late 1990s, this portfolio was reduced to zero at the start of 2005.
I mentioned two mistakes, not saving enough for retirement and investing without proper diversification. The S&P 500 Index column of Table 2 combines those mistakes, with a long-term disastrous result: going broke.
My idea of proper diversification is the 50 percent global equity portfolio, composed of 25 percent U.S. equity funds, 25 percent international equity funds and 50 percent low-risk bond funds.
Sticking with Table 2 for a moment, you can see that diversifying this way would have resulted in a portfolio worth more than $10 million at the end of 2005 – 10 times it’s starting value. That should be an ample cushion for anybody after 35 years of retirement.
Now look at the S&P 500 Index column in Table 3, which is based on taking smaller withdrawals. This portfolio ends 2005 with $14.7 million, more than 100 times the next scheduled withdrawal and in no danger of running out of money. Even though this portfolio lacks proper diversification, it survives because the retiree could get by on 4 percent withdrawals instead of 6 percent.
The portfolios outlined in Tables 2 and 3 are the same except for the rate of withdrawals. You’ll see that all the portfolios survived much better with a lower withdrawal rate.
Two obvious lessons present themselves from Tables 2 and 3. First, investors will do better if they save more for retirement. Second, a portfolio that’s properly diversified is more likely to survive decades of increasing withdrawals than a portfolio that’s not diversified.
WHEN 11 PERCENT DOESN’T EQUAL 11 PERCENT
I’d like to direct your attention back to Table 1 for a moment. Remember I pointed out that over this 36 year period, the 50 percent global equity portfolio had virtually the same return (11 percent) as the Standard & Poor's 500 Index (11.1 percent).
Judged only by their 36-year return, these two portfolios look nearly identical. Yet for a retiree taking withdrawals of 6 percent, one grew to $10.2 million while the other went broke. The reason for this deserves a separate discussion. You’ll find that discussion in an article called “Retirement: When your portfolio starts paying you.”
Here is my point: You may be able to get away with Big Mistake No. 1, failing to save enough for retirement and therefore having to take aggressive distributions, if your portfolio is properly diversified. If you are properly diversified, I would expect to find that your portfolio fell somewhere in the middle of Table 2, with 40 percent to 60 percent equity. I would not consider the portfolio properly diversified if all of it were either in fixed-income investments or in the Standard & Poor's 500 Index.
You also may be able to get away with Big Mistake No. 2, not having a properly diversified portfolio, if you have ample savings for retirement. (Bill Gates’ retirement, for instance, is likely to be comfortable no matter how he invests his money.)
But you are not likely to get away with making both these errors. If you don’t have enough money, and if the money you have invested is poorly diversified, you are asking for trouble. You could run out of money before you run out of life.
On a positive note, if you can avoid those two errors, your chances for a successful retirement are greatly enhanced. That’s what this discussion – and these tables – are about.
Table 3 represents somebody who had saved enough for retirement and could therefore withdraw conservatively. As you can see, any of the portfolios would have held up just fine.
But even though Table 3 looks very comfortable, it presents what I think is a problem: Too little money is being spent each year. For somebody with a huge fortune and a desire to leave a substantial legacy, this isn’t a problem. But I believe that most people want to live it up – and in fact I believe they should live it up – more than is implied in this table.
For example, look at the 50 percent global equity column, representing a moderate portfolio, and at the year 1985, representing 15 years after this person (let’s assume it’s a couple) retired. In that year, the couple takes out $67,014. That is about 2 percent of the value of the portfolio at the end of 1984 ($3.2 million). I believe this overly cautious approach deprives that hypothetical couple of much enjoyment that they could well afford.
By the year 2000, when the portfolio is worth more than $16 million, this table would have our couple making do on only $122,272. In order to solve this problem, you have to know when it’s wise to pull back and when it’s safe to take out more. Although it’s impossible to know this for sure in advance, Tables 4 and 5 present what I think is a pretty good solution.
INESCAPABLE LOGIC
For people who have saved enough to let their annual withdrawals fluctuate, flexible distributions let the portfolio itself dictate the withdrawals. When your portfolio is growing, you take out a bit more. When your portfolio is shrinking, you take out a bit less. There’s an inescapable logic to that.
The variable distribution plan is easy to understand. At the start of every year, you take out a fixed percentage of the portfolio’s value. Table 4 is based on aggressive withdrawals of 6 percent.
In Tables 4 and 5, we focus on only one portfolio option, the 50 percent global equity combination.
The downside of variable withdrawals is that they can vary in the downward direction as well as in the upward direction. Notice in Table 4 that the distribution started at $60,000, rose to $70,183 in 1973, then fell to a low of $52,192 in 1974, after the 73-74 bear market. That’s a 25 percent pay cut in two years, not something a retired couple could easily accept if they needed $60,000 to meet their basic needs.
However, the long-term direction of the market has been up, and in this 36-year period, that worked to the advantage of retirees who could get along with variable withdrawals.
Using the 50 percent global equity portfolio for comparison, let’s look at the results of variable vs. fixed withdrawals for somebody starting with a 6 percent (aggressive) distribution schedule. The following table shows the withdrawals every five years.
Figure A: Fixed vs. variable aggressive withdrawals
Year Fixed Variable
1970 $60,000 $60,000
1975 $71,261 $52,192
1980 $84,636 $86,396
1985 $100,521 $128,975
1990 $119,387 $233,529
1995 $141,795 $250,106
2000 $168,408 $303,311
2005 $200,015 $314,497
The next logical question, of course, is what happens to the portfolios in these two scenarios. Figure B compares the portfolio value at the end of these same years.
Figure B: Portfolio value, fixed vs. variable aggressive withdrawals
Year Fixed Variable
1970 $974,588 $974,588
1975 $1,007,948 $1,042,962
1980 $1,490,372 $1,605,575
1985 $2,528,962 $2,632,109
1990 $3,921,139 $3,554,259
1995 $5,883,922 $4,503,403
2000 $7,590,676 $4,787,221
2005 $10,210,781 $5,287,993
Obviously, the fixed withdrawal schedule was more effective at building up a portfolio. That would be good for a retiree with modest income needs and a desire to leave a big legacy.
But for retirees who want to live it up without running out of money, I believe the variable approach is better. Table 4 shows that the bear market of 2001-2002 reduced the 2003 distribution to $256,457, a 15 percent drop from its peak in 2000. But that was still far ahead of the 2003 fixed distribution (Table 2) of $186,717.
You could make a similar comparison of the 50 percent global equity portfolio with conservative withdrawals. You would find that in 1985, 15 years after retirement, the withdrawal was $67,014 (fixed, from Table 3) vs. $118,983 (variable from Table 5). By 1995 the difference was $94,530 (fixed) vs. $286,472.
WHEN LESS BECOMES MORE
In case you missed it, there’s something else mighty interesting about that 1995 conservative distribution (4 percent) of $286,472. It’s larger than the aggressive distribution (6 percent Table 4), which was $250,106.
This leads to another very interesting point: Less (conservative distributions) can eventually become more. In other words, 4 percent of a big number can be more than 6 percent of a smaller number.
The reason is obvious: More money is left in the conservative portfolio in the early years. That money grows and eventually produces a bigger paycheck.
This takes us back to the dilemma I posed earlier.
You can decide to take out more money in the early years of retirement, knowing you are more likely to be alive and healthy and able to enjoy the bigger withdrawals. The cost of this, however, may be less money to spend later.
You can decide to take out less money in the early years, hoping to have substantially more money later. The cost of this choice is that you are less likely to be able to fully live it up in your 80s and 90s than in your 60s and 70s.
This is a decision that should be made only after some soul-searching conversations that should certainly include a spouse or partner, if there is one, and should probably involve an advisor as well.
One way to think about these last four tables is to rank them in order of how desirable they are. I think Table 5, representing the conservative flexible distributions, is the most desirable. It represents the most financial strength. But it requires a portfolio big enough to meet your needs with only modest withdrawals, and those withdrawals must be big enough to more than meet your basic needs.
The least desirable scenario is represented by Table 2, the aggressive fixed distribution schedule. It implies the least financial strength. The portfolio must be tapped aggressively just to meet your basic needs.
When you’re saving for retirement, more is better. With a bigger pool of assets, you can sip from that pool instead of drinking deeply.
SAVER/SPENDER COUPLES
Most couples I know have one member who is more oriented toward saving and one more oriented toward spending. In any marriage or partnership, this can be a continual tug-of-war. One person typically may be frugal and anxious about running out of money. The other can believe that “money is for spending” and have a very hard time pinching pennies when the couple has a big bank balance.
The variable withdrawal schedule is a simple and sensible way to balance these needs. It manages to serve the competing needs of frugality and luxury.
The anxious saver knows that if the market goes down, spending will go down as well. And if the market goes up, only a small minority of the gains (4 percent or 6 percent in the examples we have shown) will be spent; the rest will remain in the portfolio.
At the same time, the eager spender will know there’s always hope for better days ahead when the market booms.
OVER-OPTIMISM
It would be easy to study these tables and conclude that retirement carries little risk as long as you avoid the extremes of taking out too much and of investing your money poorly. The tables include the comfortable knowledge of how everything turned out. But in 1970, nobody could have predicted the twists and turns of the market, the economy and of inflation over the forthcoming 36 years – to say nothing of the knowledge of which investments would pay off and which would not.
If somebody in 1970 had published an accurate table of investment returns and inflation through 2005, few people, if any, would have believed it.
The past 36 years were a time of generally rising prices and of prosperity. The next 36 years may be quite different, and there’s no way to know.
When you are taking money out of a portfolio, the order of returns matters a lot. If the first 10 years of your retirement are plagued by frequent losses and small gains, and you’re withdrawing money every year, it will be extremely hard to recover even if the next 20 years are very prosperous.
These are things that cannot be known, and the only solution is one I mentioned before: Save more money than you think you’ll need.
FIXED VS. VARIABLE WITHDRAWALS
With a fixed withdrawal, the concern is whether (and when) your portfolio might run out of money. Fixed withdrawals imply that you have non-negotiable expenses that have to come from your savings, no matter what. Basic costs like food, clothing, shelter and health care fall in that category. If meeting these needs puts a strain on your portfolio, you probably haven’t saved enough. You are in a position of relative weakness.
For example, you must be able to take out $70,183 (Table 4) in 1973 but only $52,192 two years later – and somehow do that without getting spooked into thinking that the market will just keep going down. Not everybody can do that.
The issue with variable withdrawals is the variations and how well you’ll be able to withstand them. Variable withdrawals require the ability to get by on less if necessary. That might mean less travel, less entertainment, putting off the remodeling job on the house. Whatever it is, you can afford to postpone it waiting for better days. When you can do that, you are in a position of relative strength.
There’s another issue with variable withdrawals: They don’t make any adjustment for inflation. They assume your portfolio will grow enough, even after withdrawals, to keep up with rising prices and with your needs.
AGGRESSIVE VS. CONSERVATIVE
It should be obvious by now that I prefer conservative withdrawals instead of aggressive ones. But everybody’s circumstances are different, and there are many moving parts to this choice.
One “moving part” is the priority weighting that you give to the ability to spend now vs. the peace of mind you may get from invading your portfolio more lightly. Immediate spending power comes from distributions, and fixed distributions are more reliable than variable ones. Peace of mind comes from what happens to your portfolio. And for the most part, your portfolio will be in better shape with variable distributions than with fixed ones.
An important factor is health. Statisticians tell us that a healthy couple, both age 65, face a 50 percent likelihood of having at least one of them live to age 92 and a 25 percent chance that one will live to 97.
The conservative distribution tables show that retirees who live to a ripe old age can reap big benefits from taking out less during their earlier retirement years. However, as people grow older, their health and vigor usually decline. Many who postpone spending until age 85 won’t be able to take full advantage of their larger spending power.
Does this mean you should spend more while you’re still young? Maybe, maybe not. If you’re too optimistic about your investments and spend more than you should in the early years, you may have to cut back significantly later. You’re not likely to be happy about that.
On the other hand, if your health and longevity are quite uncertain and you have saved a big pool of assets, the onset of retirement may be a good time to start living it up.
YOU CAN LIVE IT UP
As these tables show, planning a carefree retirement is a series of tradeoffs. Winding your way through them requires careful thought and discussion. Unless you have more money than you think you could ever need, you must make some difficult decisions, the outcome of which will depend on future developments beyond your control.
But if you save aggressively while you’re working, keep your basic costs of living in check, choose carefully among the alternatives and invest intelligently while you control your risks, you can indeed make your retirement dreams come true.
Disclosure for Tables
Returns in Tables 1 through 5 are based on Dimensional Fund Advisors institutional index funds. The equity parts of portfolios identified as global equity are made up of the following asset classes: 12.5 percent each in U.S. large-cap, U.S. large-cap value, U.S. micro-cap and U.S. small-cap value; and 10 percent each in international large cap, international large-cap value, international small cap, international small-cap value and emerging markets. The fixed-income parts of those portfolios are invested in equal parts of two-year and five-year bond funds.
Data in the tables were generated by Merriman Capital Management. Figures in the tables do not represent actual returns, only hypothetical ones, and are presented for purposes of illustration and comparison of various withdrawal options. Management fees of 1 percent annually are assumed in Tables 1 through 5. The tables assume that rebalancing and payment of prorated management fees, when applicable, occurred monthly.
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