Friday, June 06, 2008

Manage Retirement Withdrawals Carefully

The Risk of Ruin for Retirees by Andy Mayo from Investopedia, shares why average returns aren't sufficient. When withdrawing funds the sequence of return may have much more impact than average return. The article demonstrates this by taking the 17 year period from 1987 to 2003, during which there was an average annual return of 13.47%.

Taking a $100,000 nest egg and withdrawing an inflation adjusted $10,000 each year left the account with $76,629 at the end of 2003. Not bad.

However, the article then reverses the order of the returns, starting at 2003 and going to 1987. While the average annual return is still 13.47%, the account balance after 17 years is -$187,606. The reason is that negative returns in years 2-4 significant reduce the account, while withdrawals are being made. Since the money is withdrawn, it can't help the account recover in later years.

I think there are two lessons to be learned from this article:

  1. Use probability analysis to determine the nest egg needed. The current best approach is Monte Carlo analyses that run a thousand scenarios with randomized returns. The analysis of our savings shows we have about a 90% chance of not outliving our savings.


  2. Adjust spending with market returns. Simply, spend below target in the years that returns are down and spend above target in the high return years. That way savings are preserved in down years, allow them to recover when the market has a good year.

The other strategy we are using is to have 3 -5 years of expenses in short term (3-5 years) fixed income investments. By doing this, we guarantee that we don't have to sell low to create income. And if the market does well, we can spend a little bit more :-)

For more on Reaping the Rewards Reflections , check back every Friday for a new segment.

This is not financial advice. Please consult a professional advisor.

Copyright © 2008 Achievement Catalyst, LLC

2 comments:

Konstantin said...

You probably mean 10% chance of outliving your savings, I suppose:-)

Super Saver said...

Konstantin,

You are correct. It would have been a big gamble to retire with a 90% chance of outliving our savings:-)

Thanks for catching the typo. I left out the word "not" just before "outliving." I have made the correction and it now reads "a 90% chance of not outliving our savings." A much better place to be :-)