If you put the same assumptions into 10 different retirement calculators, you will most likely get 10 different results. The largest number may be more than twice as much as the smallest. But retirement doesn't give you a second chance — measure twice and retire once.
The variations among retirement projections result mostly from differences in their assumptions. Six assumptions are significant in calculating safe withdrawal rates during retirement: inflation, average return, portfolio volatility, investment mix, longevity and lifestyle. Furthermore, these assumptions are interrelated and interdependent.
Many people wrongly suppose they can safely withdraw and spend from their portfolio whatever they earn on their investments. Nothing could be further from the truth.
Imagine you retired in 1973 with a portfolio producing a $10,000 annual return. In today's dollars, that amount of money is equivalent to $48,400. But spending all of your dividends and appreciation each year means your portfolio will not grow to keep up with inflation.
Now, at the end of your retirement, your portfolio is still only generating $10,000 a year and your lifestyle is impoverished. So your withdrawal rate must be low enough to permit some funds to remain in your portfolio so future withdrawals can appreciate with inflation.
Inflation is a huge assumption, and most projections don't handle it well. Retirement plans tend to forecast the rate of portfolio returns and inflation separately. On average, stocks earn 10 percent to 12 percent, and bonds earn 6 percent to 8 percent. Inflation runs about 3 percent to 5 percent. Those are huge ranges and can produce very different results. With so much wiggle room, the most favorable assumptions allow you to withdraw and spend about twice as much as the worst cases.
A better retirement planning method is to factor inflation out of your investment returns. Whatever inflation is currently running, stocks earn on average a 6.5 percent real return over inflation, and bonds earn about 3 percent above inflation. Factoring inflation out of average investment returns removes some of the wobble factor in retirement projections.
You should also inflation-protect your portfolio through asset allocation. Some asset classes offer protection against loss of purchasing power, and at least half of your portfolio should be in these asset classes. Hard asset stocks provide an inflation hedge. So do foreign bonds and foreign stocks.
Stocks may earn, on average, 6.5 percent over inflation, but this estimate is too optimistic for planning purposes. To talk about "average stock returns" is like noticing that the average number on the roulette wheel is 18.5. Stocks may average 10 percent to 12 percent, but only four times in the last 70 years have stocks actually returned in that range.
Reducing the volatility of your investments is one reason why asset allocation is so important. Dividing your investments among asset classes with low or negative correlation is the best strategy to reduce portfolio volatility and boost returns.
Most retirement projections assume your portfolio will have a fixed asset allocation that doesn't change during your 30-year retirement. But in fact, your asset allocation should start with a strong equity bias and gradually grow more conservative as you age. Static asset allocation assumptions may range anywhere from 40 percent to 25 percent of fixed income.
Over the past five years, the average annual return for U.S. bonds was only 4.0 percent. The greater the allocation to fixed income, the less likely the portfolio will keep up with inflation and provide adequate growth for a long retirement. Maintaining an equity bias is critical during the early years of retirement.
Many plans assume the equity allocation will be primarily large-cap U.S. stocks such as those found in the S&P 500. But a more balanced allocation would include small cap, foreign stocks and emerging markets.
In the past five years, the S&P 500 has averaged 10.1 percent, S&P Mid-Cap 14.9 percent, and the Russell 200 Small Cap 12.9 percent. The EAFE Foreign Index averaged 19.7 percent over the same period, and emerging markets averaged 31.5 percent. Obviously, with such disparate returns, asset allocation matters a great deal. We recommend investing significantly in equities for appreciation but diversifying both for safety and to boost returns.
Most retirement strategies make an assumption based on your age at retirement. The earlier you stop working, the lower the percentage of your assets you can withdraw and still have money until you reach 100 years old.
Many retirement plans are predicated on a 30-year retirement. At age 65, your average life expectancy is 86, or 21 years. But half of today’s retirees will live longer, some well over 30 years. If a husband and wife both retire at age 65, the odds are 40 percent that one of them will live until age 95.
Average life expectancy makes a poor planning statistic. Compare it to making a doorway 5 feet 10 inches tall to accommodate the average person. Men will bump their heads on the average doorway, and women will run out of money in the average retirement projection. Doorways are 7 feet tall and ceilings are 8 feet tall for a reason.
Your specific demographics can skew your life expectancy significantly. Not only do women live longer, but so do those who have enough money to plan. Readers of this column probably live longer on average than those who don't, and we recommend planning to have enough resources for a comfortable lifestyle until age 100. A 30-year retirement may be adequate, but we recommend planning to have money until you reach at least age 100.
Finally, lifestyle assumptions can skew retirement projections. Many assume your lifestyle in retirement will be only 70 percent of the lifestyle you enjoyed while you were working. Others assume you will be in a much lower tax bracket, and they fail to discount the assets of your traditional retirement accounts adequately. It is just as likely, and much safer, to assume that spending and taxes in retirement will continue to rise.
For our retirement assumptions, we try to play it safe but not to an extreme. We assume longevity to 100 years old and earnings of at least a bond portfolio, about 3 percent over inflation. These assumptions will not always be met, and even with these conservative assumptions, blindly following them will result in about a 7 percent failure rate.
Therefore, we urge you to update your retirement plan annually to make adjustments and course corrections. These adjustments include changes not only to your asset allocation but also to your lifestyle and thus the amount of your withdrawals.
Marotta Asset Management, Inc. of Charlottesville provides fee-only financial planning and asset management. Visit www.emarotta.com for more information. Questions to be answered in the column should be sent to firstname.lastname@example.org or Marotta Asset Management, Inc., One Village Green Circle, Suite 100, Charlottesville, VA 22903-4619.
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