When people save for retirement one of the most common questions that comes up is how much do I need to save? How much do I need to have for retirement? At some point in time, retirement, the issues change and the question becomes how long will your money last?
Naturally there are some assumptions and questions that need to be asked like how much income do you need? What rate of return should you assume? Let's take a look at Bill and Cindy and their retirement scenario.
Bill and Cindy need money
Bill and Cindy are both ready to retire. They have saved $500,000 in investment savings and their basic question is how long will this money last. As much as that sounds like an easy question to answer, it requires some more detail before we can provide an answer.
Firstly, we have to come up with a Withdrawal Rate. In other words, the longevity of Bill and Cindy's money depends on how much money they need to live on. The withdrawal rate is expressed in terms of a percentage. If the withdrawal rate is higher, they risk running out of money faster than if they choose a lower withdrawal rate. Bill was a little more aggressive and a little more optimistic. He was hoping that their money could generate them about 8%. Cindy on the other hand felt they should be a little more conservative and she thought 6% is more realistic. They decided to use a 7% withdrawal rate.
Rate of return
The next assumption that we have to determine is the actual rate of return. In essence, we need to make an assumption about what the investment is going to earn. You might be wondering what the difference is between the withdrawal rate and the rate of return assumption. While most people might think they are the same number, they do not have to be. For Bill and Cindy, they might need 7% on their $500,000 which would translate to $35,000 per year of income. But what if they are investing primarily in GICs which only generate about 4% per year. In this instance their $500,000 would increase each year by 4% but it would decrease by 7%. Their capital would start to deplete and their money would last 20 years.
The flaw of averages
So far in this example, we have used simple numbers based on average straight-line assumptions. One of the problems with using straight-line assumptions is that the world in which we live does not move in a straight line. Your investments might earn 3% one year, 10% the next 0% the year after that and 7% in the fourth year. Although, when you average these years, you get about 5% this variation in returns can have a huge impact on the longevity of your money when taking money out.
Monte Carlo analysis
When doing retirement income planning analysis, it is very important to look at a number of different scenarios and variations. Monte Carlo simulations are a tool to help look at a myriad of different possible outcomes given a variety of different scenarios. Fidelity Investment recently did some work on withdrawal rates and the impact of those withdrawal rates on longevity of assets. Let's go back to Bill and Cindy and see how Monte Carlo Analysis works for them.
Bill and Cindy have $500,000 and they ideally would like to have $35,000 per year of income from that money. According to Fidelity's research, instead of using an average return, they said what if Bill and Cindy were ultra conservative investors with 80% GICs and 20% equities. Based on hundreds of scenarios of past data, Their money would only last 16 years in average market conditions and might only last 14 years in an extended down market environment. The fluctuations of the market reduced their longevity by about 5 years (20 years if we used average returns).
If Cindy went to a more moderate or balanced portfolio to try to get higher returns, their money would last 19 years in an average market and 13 years in an extended down market. For comparisons sake, if they went with an aggressive portfolio which would have 85% equities and15% fixed income, their money would last 22 years in an average market and only 12 years in an extended down market.
My two cents
When planning for retirement income, consider a number of different scenarios rather than relying on one potentially misleading long-term average
It is more difficult for you to control the rate of return. You can only really control the withdrawal amount, which can dramatically affect the longevity of your portfolio. You should really take careful consideration in determining your withdrawal rate. Any withdrawal rates in excess of 4% can dramatically increase the risk of running out of money.
Based on Fidelity's research, it appears that most people are overly optimistic about how much they can withdrawal. While most people think higher returns means your portfolio will last longer, Monte Carlo analysis suggests that risk can also hurt the longevity of the portfolio.
In essence, the new retiree will continue to live in an environment where they will struggle to find balance between risk and return. On one hand they can't afford to be too conservative or they will have to live on less money or see their investments deplete too fast. On the other hand, more risk could also hurt the longevity of a portfolio.