It must be that time of the year again. Retirement hysteria time. Usually in the new year I start seeing a slew of articles on how your retirement is at risk, how you cannot possibly retire now, and the theme for the last few years – how high stock market valuations and low interest rates will guarantee that either you are going to work forever or you are going to retire with a much lower living standard. This time the offending piece was in Kiplinger’s of all places, which was brought to my attention by one my weekly econ reads, Dash of Insight. Ughh…is about the best thing I can say about all this stuff. Jeff at Dash of Insight has some good links rebutting some of the flaws in the piece (basically garbage in, garbage out) and that’s all I’ll say about that piece. But today I wanted to talk about something else. A process to think about retirement.
Most people constantly search for deterministic answers in a complex, probabilistic world, forever doomed to frustration. There is no one answer. There is an array of future possible answers which with some good, state of the art, careful analysis you can get a reasonable range of expectations which you can prepare for and dynamically adjust to as you proceed along the path. First, lets look at the ways these retirement projections are made in the first place.
There are two basic ways to figure out a reasonable safe withdrawal rate (SWR) for retirement. On way, is to look back in history, take a look at what retirement has looked like for all past retirees given the asset class returns of the past. This gives you a historical SWR for all past retirees for a given period of time, usually 30 years. This is where the 4% rule comes from. As it turns out, the 4% rule is defined by the retirement period beginning in 1966, the worst time in history to retire. This approach is nice in many ways. It’s easy to study the events and conditions the led to these outcomes and compare them to the present day. As humans we like to create narratives. It helps makes sense of the world. The problem with this approach is that it is only one version of events, one future path that was possible at the time of retirement. That brings in the second approach, monte carlo simulations. Basically, run a simulation of possible future retirement outcomes with thousands and thousands of possible outcomes and then calculate the SWR that would work in most of these possible future outcomes, usually something like 80-90% success rate. You need to be real careful with monte-carlo not to use overly conservative success rates. The number one issue for me with monte carlo analysis is that is highly dependent on initial assumptions, made by humans, most rife with biases. As in the example I cited in the first paragraph, garbage in – garbage out. For example, if you’re a pessimist your initial assumptions will probably be too low and vice versa for the eternal optimist. But these tools in the right hands can give you some really useful data on which to base a retirement plan and process.
There have been many improvements to the old style historical SWR analysis. More diversified portfolios and flexible spending strategies being the two of the best. Michael Kitces does some of the best writing on safe withdrawal rates. Here is a good example. And I have written on many of these myself. And the same goes for motel carlo analysis. The best state of the art analysis that is easily accessible is the one done by Vanguard. No surprise right? Once a year they come out with their VMM (Vanguard Market Model) that looks at a broad range of asset classes and comes out with a range of return expectations. You can find the 2017 VMM here. This is a must read for me every December. All these projections are put into an a great on-line monte-carlo simulator and then they give you a super easy tool for you to use. Lets look at some current retirement scenarios with this state of the art tool.
Below is the output of the tool assuming a 4% SWR and the standard 60/40 stock, bond portfolio. Hmmm, not so much cause for hysteria huh? A 4% SWR has a 92% chance of survival and a very large probability of ending retirement with many times your initial wealth. So, odds are 4% SWR is still a pretty good starting assumption.
And here is something telling. Try running the tool with a 100% stock portfolio and then with a 100% bond portfolio. You have a better chance of portfolio survival with a 100% stock portfolio than a 100% bond portfolio. This is one of the very real consequences of lower rates for retirees! Personally, I run my numbers targeting an 80% chance of survival. As the great investment writer William Berstein said,
“the historically naïve investor (or academic) might consider reducing his monthly withdrawals to a very low level to maximize his chances of success. But history teaches us that depriving ourselves to boost our 40-year success probability much beyond 80% is a fool’s errand, since all you are doing is increasing the probability of failure for political, economic, and military reasons relative to the failure of banal financial planning.”
Or as I always tell myself in times of doubt – you have to Dare to be Great! Here are the numbers for 3 portfolios using an 80% chance of survival: 85/15 stocks bonds – 4.9% SWR, 60/40 stocks bonds 4.9% SWR, 15/85 stocks bonds – 4.3% SWR. Average ending wealth goes down also from 85/15 stocks bonds to 15/85 stocks bonds.
Yes, stocks are priced for lower returns in the future. Yes, interest rates are lower than they’ve been in the last 30-40 years. But that doesn’t mean the 4% SWR rule is dead. We’ve had these situations in the past. Historically speaking in order for the 4% SWR rule to fail returns would have to be worse than returns experienced in the period starting in 1966, where 60/40 portfolio returns were negative on a real basis for the first 10 years! It is certainly possible, as the simulations show, but it is not the likely outcome right now. And we’re not just a bunch of passive robots who would not adjust to possible negative situations. Monitoring your current withdrawal rate as an early warning indicator, having a flexible spending strategy, and/or running TAA portfolios with built in risk management and historically higher SWRs will all increase your chances of retirement success.
I have to put this section in for all those who just can’t do any of this and just see risk, risk, risk on the horizon. It is possible to retire with no stocks at all and have a reasonable withdrawal rate in retirement. I’ve talked about this in the past as well. Here are the latest projections for SWRs from dedicated income sources. Data is from the Retirement Income Dashboard which is updated regularly. SWRs from 3.6% to 5.5% from fixed sources. Not too shabby.
These are viable options for older people who are quite risk averse. Personally, I see these kind of portfolios as rife with risks I’m not willing to take, namely zero opportunity for upside success, but we are all in different situations and hey we all have our own demons to deal with.
The last thing I want to talk about is the way I look at retirement. First of all I don’t use the word retirement. The traditional meaning of the term is such a static view of the world and humans, and is practically meaningless if you are young and looking for an alternative path. I use the term financial freedom or independence. And I have a model. It’s a variation of the old three legged stool model used by financial planners. I guess I should call it the Investing For A Living Financial Freedom Model.
The three legs in my model are investments, spending, and work income. I factor in social security into the spending leg as a reduction in spending in future years. The three legs are all levers that I can control, some more than others for sure. I make use of all three as needed.
I have currently entered my 12th year of financial freedom. In practical terms that means I am in my 12th year of withdrawals from my portfolio. But that doesn’t mean that portfolio withdrawals have been consistent. The real world is not a spreadsheet. Nor do I want it to be. In 2006-2007 I used work income to fund a degree in investment management and travel all over Asia. In certain years, like 2009, I used work income to fund a move back to the US and to minimize portfolio withdrawals during the financial crisis. In 2012, a year of very high medical bills, we relied on reducing spending to limit portfolio withdrawals. And we know many people who are following a similar path and combining investments/savings, work, and frugal living to have financial freedom now. If investment returns are much lower than my conservative estimates in the future, no doubt we will leverage the income and spending legs. It’s all very dynamic and quite flexible. Most importantly it helps me deal with any the uncertainty and anxiety that enters my thinking.
In summary, the future is uncertain. Nothing you can do will change that. None of your worrying will change that. No forecast will be correct for very long (at best). And your initial launching point may not be as good or easy as the past. But there are state of the art tools that you can use to come up with a reasonable plan and in combination with a flexible dynamic model that adjusts to changing conditions you can be well on your way to financial freedom.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.