I am often asked about how someone should invest in retirement. My first reaction is usually to wonder why they’re so worried about it. Just as investing for physicians is 95% the same as investing for everyone else, investing in retirement is 95% the same as investing before retirement. It seems to me that if you can figure out how to stash away enough money to retire on, then it shouldn’t be that hard to figure out how to keep investing that money. However, there are few unique issues unique to retirees that are worth discussing, so this week I’ll have a series of five posts discussing them.
The Sequence of Returns Issue
The first thing that needs to be understood about investing in retirement is the sequence of returns issue. Basically, this is the fact that not only do your returns matter, but WHEN you get those returns matters. Many times, just to keep things simple, we use average returns for an investment over decades when illustrating investing principles like compound interest and when doing financial planning. However, in the real world, and especially with volatile, high-return investments like stocks, returns are very irregular. Even if you have a solid average return of 8-12% on an investment, if you get a long series of poor returns at a critical time in your personal investing timeline, it can sink your plan.This is why safe withdrawal rate studies come out with numbers in the 4% range, even when the investments historically might have averaged 6-8%.
Dealing with this issue should be one of the biggest focuses in any type of retirement planning. In short, your plan needs to account for the fact that your investments may have terrible returns for 5 or 10 years during the critical time period composed of perhaps 5 years prior to your retirement and 10 years after your retirement. There are a number of strategies for dealing with this. Perhaps the most common is to de-risk the portfolio (ie. a less aggressive asset allocation) during these time periods. Increasing bonds with age is commonplace. However, Wade Pfau has demonstrated that the ideal strategy may actually be to increase your stock allocation later in retirement, but the effect of both strategies is similar- a lower stock allocation during the critical years. Other strategies include a “buckets of money” strategy or a TIPS ladder strategy where you basically have the money you intend to spend during the critical period outside of volatile instruments. Using a pension + SPIA + SS for your basic income needs has a similar effect. Finally, many investors use a “adjust as you go” strategy and watch their returns carefully those first few years, adjusting their spending down if the dreaded poor return sequence materializes.
Another major factor retirees need to deal with is the dragon of inflation. Far too few investors realize that their “opponent” in investing, both before and after retirement, isn’t other investors or “Wall Street.” It’s inflation, not inflation as measured by the government CPI, but their own personal rate of inflation. We all know of a widow living on a “fixed income” that on an after-inflation basis is becoming lower each year. This is less of an issue before retirement, when (hopefully) your income and annual savings is increasing each year with inflation and you have plenty of high-risk, high-return investments that are growing faster than inflation. Again, there are lots of strategies available to deal with inflation, including continuing to hold some percentage of risky assets in the portfolio, using inflation-adjusted pensions, SPIAs, and Social Security, using a higher percentage of inflation-linked bonds on the fixed income side, and owning your residence, which will hopefully eliminate a big chunk of your expenses that rise with inflation.
I often discuss the concept of a safe withdrawal rate on this site, but that is often while doing a calculation to determine how large your nest egg needs to be for retirement, to give you a number to shoot for. As a retiree, withdrawal rates become much more interesting, since your current lifestyle is dramatically affected by your selected portfolio withdrawal rate. Pick a rate too high, and you’re likely to run out of money before time. Pick a rate too low, and you may unnecessarily impoverish your lifestyle just to leave more money to your heirs, charity, and possibly even the IRS. The classic Trinity Study gave us the often-quoted “4% rule” but it is important to understand where that rule came from and what it means. Basically, using HISTORICAL data (and the future may not resemble the past, especially given our very low interest rates and higher than average stock and real estate valuations), the authors demonstrated that a 50/50 portfolio of large cap stocks and intermediate government bonds was extremely likely to last throughout your retirement if you only took 4%, adjusted to inflation, out each year. Here’s a copy of that data updated throughout 2009, pilfered from Wade Pfau’s site.
Every potential retiree, especially an early retiree, should spend some time staring at these charts. The point of the Trinity Study wasn’t to determine whether a safe withdrawal rate (SWR) was 3.5% or 4.5% or 4%, but to demonstrate that it wasn’t the 6%, 8%, or 10% that many investors and planners were using up until that time. It is also important to understand the concept best shown in this chart:
This shows where the “4% SWR” comes from, i.e. a period of time between 1960 and 1975. Basically, if your “critical investing time period” included the Great Depression or the stagflation of the 1970s, you better not be taking out more than 4% a year. However, if your own personal critical investing window was any other time, you may have been just fine taking out 5-6% a year. That might seem like a tiny difference, but on a $2 Million portfolio, that’s the difference between spending $80,000 a year and $120,000 a year, a 50% difference.
Also bear in mind that these charts use gross income, and never include taxes OR investment fees. If you’ve chosen to pay 1/4 of your retirement income as a 1% AUM fee to an advisor, you’re going to need to live on 25% less money in retirement, although Michael Kitces makes a good argument about how a 1% AUM fee really only reduces the Safe Withdrawal Rate by 0.4% rather than 1% per year. That’s still $8000 a year on a $2 Million portfolio, hardly insignificant.
In Part 2 of this series, we’ll start dealing with how these three big issues that can dramatically affect investing in retirement.
What do you think about these three big issues retirees face? Comment below!