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BusinessWeek Investor: Retirement
That Nest Egg May Have Hidden Cracks
Advisers say the old projection formulas don't hold up
How much income will you have to live on when you retire? For most people, that's just another way of asking: "How much money can you take each year from your retirement savings?" Sure, Social Security and, for some, old-fashioned pensions still provide an income base. But for a growing majority of current and future retirees, the skill they show in managing their own nest eggs will make the difference between living large and scraping by.
The old formula was simple: Project what you'd expect your retirement portfolio to earn each year, reinvest some earnings as a hedge against rising prices, and spend the rest. A moderately aggressive retiree with $1 million invested 60% in stocks and 40% in cash and bonds could, based on average returns since 1970, expect to earn 12.2% a year. Even with some protection against inflation, that's enough to support a healthy 8% rate of withdrawal--$80,000 annually--or even more if the retiree is willing to draw down principal.WRONG ROAD. Today, however, that conventional wisdom looks more and more like a road map to the poorhouse in your old age. The problem is basing your calculations on average returns--the way countless retirement calculators used by planners and Web sites do. Over the long run, those averages will include both bull markets and bears. But for retirees, the timing of market breaks is crucial. Run into a bear market soon after you retire, and your portfolio may be so ravaged that you never get a chance to participate in the next upswing.
To protect yourself, you're going to have to scale back your spending plans. Indeed, the new consensus from a growing body of research by financial planners and professors suggests that a "sustainable" withdrawal rate may be no more than 4% to 5% of the account's initial value, plus adjustments for inflation.
That's likely to come as a shock to millions of workers as they firm up plans for their golden years. After all, if you're going to need $80,000 a year, the new consensus says you'll need to save not just $1 million, but $1.6 million to $2 million. "When you think: `Can I live on 4% of my assets?' you're likely to decide that you've got to step up your saving," says Sue Stevens, director of financial planning at Morningstar Associates.
These timing considerations haven't gotten much attention because they don't have a big effect when people are building up assets. "If you're in buy-and-hold mode, the sequence of good years and bad doesn't really matter," says Eleanor Blayney of Falls Church (Va.) planners Sullivan, Bruyette, Speros & Blayney.
But if you're withdrawing money, when the bad years hit can be crucial. Take a couple who retired in 1968 with $1 million invested 60% in stocks, 30% in bonds, and 10% in cash. Over the next 30 years, that mix paid an average annual return of 11.7%--enough to sustain an 8.5% withdrawal rate for nearly 30 years (chart). But that average return combines the bull market since 1982 with the investment disaster of 1973-74, and our couple had the misfortune to run into the bear first. Mutual-fund firm T. Rowe Price estimates that if you combine the couple's $85,000-a-year spending with that 40% drop in stock prices and the high inflation of the 1970s, they would have gone broke by 1981. So when the bull run started a year later, they wouldn't have any cash left to invest.
Rather than basing plans on average returns, the new approach uses estimates based on probabilities. Planners measure the odds by plugging historical returns and volatility of stocks, bonds, and cash into their computers and running hundreds of scenarios. The goal is to find a mix of assets and a withdrawal rate that can pay off for 20 or 30 years in 75% to 95% of those market scenarios.
For such long horizons, "you can't count on more than a 7% withdrawal--and a lot less than that if you want to give yourself a raise for inflation every year," says Philip Cooley, professor of finance at Trinity University in San Antonio. With inflation protection, the sustainable drawdown drops below 5%. And even that requires a higher allocation to stocks--40% to 75% of a portfolio--than the 25% to 60% that most planners have recommended for retirees in the past. "Most of my clients have 65% in stocks, but I like to go as high as 75%," says William Bengen of Bengen Financial Services in El Cajon, Calif.
With that much money in stocks, you might feel more vulnerable than ever to market swings. Above all, you don't want to have to sell stocks when prices are depressed. So Frank Armstrong, president of Managed Account Services in Miami, recommends mentally dividing your portfolio into two "buckets"--one for stocks and one for fixed-income investments. The latter should be large enough to cover five to seven years' expenses. You draw down the fixed-income account, and you replenish that account by selling stocks--but only when stocks have had a winning year. "With a seven-year reserve, you can ride out any bear market without having to sell stocks," says Armstrong.
A 4% to 5% spending rate offers security, but it creates other problems. First, you won't have as much money to spend as you would with the old formulas. And if you allow for cost-of-living hikes, your income will be backloaded: You'll have relatively less to spend from age 60 to 75, when you're still fairly active, and more to spend when you're 80, 85, or 90, when discretionary income won't count as much.TOO MUCH SAVINGS? This cautious approach also means that you have high odds of leaving behind a huge estate. Starting with $1 million and a 5% drawdown rate, you have a 50% chance of leaving behind more than $1.4 million--money you could have spent on yourself, had you been certain of your investment returns.
To solve these problems, Blayney recommends a flexible approach. The discipline of the low drawdown rate helps new retirees get used to managing their spending through their first five years out of work, she says. But after that, "look at your portfolio and your needs every year, and make adjustments depending on the markets," she says.
The other way to reduce the danger of outliving your money is to share the risk. Coupled with the coming mass retirement of the baby boom generation, the new view on spending could provide a huge boost for the insurance industry and its annuity products. Insurers argue that fixed or variable annuities can guarantee lifelong income with higher payout rates. Even with their fees, annuities can return 7% to 8% on the funds invested.
For those whose savings don't measure up, annuities will make sense. Even some better-off retirees may want to buy protection by investing part of their nest eggs in annuities--especially if they expect to beat the average lifespan. But planners maintain that retirees can thrive even under the tighter formulas if they exercise foresight and stewardship. For the millions of baby boomers who will switch from retirement saving to spending in the next decade, the time to start crunching the numbers is now.By Mike McNameeReturn to top