Planning For Retirement

May 5th , 2019

How Much Is Enough?

A common question people ask on their journey to financial independence and early retirement is “How much do I need to safely retire?”. The short answer is about 25 times your yearly expenses. The result is commonly referred to as the 4 percent rule, which has a more in detailed paper and we will go over some of the highlights. This means that if your yearly expenses round out to about $40,000, then you need to have saved up $1,000,000 to retire today. The back of the envelope reason why this works is because the stock market has historically given about 7% every year and inflation has been about 3%. With these two numbers you can calculate that your portfolio is netting about 4% every year (adjusted for inflation) meaning that you can spend about $40,000 every year without touching the principal (again adjusted for inflation), which not coincidentally is your yearly cost of living. A person with this portfolio and living expense can safely retire because their savings is netting enough returns to pay for their cost of living. If they had any less money, then they would eventually go bankrupt (due to compounding loses). If they had any more money, then they would be able to leave an amount greater than the original principal to their children (due to compounding gains). The main age old saying to keep in mind is that “past performance is not indicative of future results”. This just means that things are bound to change and you need to adapt according. This does not mean that you should do little to no financial planning today, since you can not exactly predict the future.

How Was 4 Percent Derived?

The paper used historical data to try and see if a person’s retirement portfolio would allow them to remain financially independent until they are finished with retirement. The researchers created a three dimensional table that has an axis for the following:

And for the cross product of those factors they calculated the “Portfolio Success Rate”. In this experiment “success” was defined as having a non zero amount of money in your portfolio after you are done being retired. “Success Rate” was determined by taking these hypothetical portfolios and running them against the data from 1926 to 1995. For the almost 70 years of data there are about 55 years of portfolio start dates that need to last 15 years, and if 50 of them succeed, then the rate is ~50/55 = ~91%. The final table looks like this:

Portfolio Success Rates

Source

As the note says in the paper and the table, the researchers used the S&P 500 index to represent a stock portfolio and long term, high grade corporates to represent a bond portfolio. All compositions are just weighted between the two sources. Takeaways From The Table

The most insightful part of the study is how the three factors (Payout Period, Portfolio Composition, Withdrawal Rate) correlate with success rate. When analyzing the three factors we get a better understanding of where the 4% rule came from and how we can financially plan for our futures, since every individual has different financial goals (hence the “personal” part of “personal finance”).

Payout Period

The overall trend with payout period is that regardless of the portfolio composition or withdrawal rate you decide the longer you need your retirement portfolio to last the less chance that portfolio will outlive you. The mathematical reason behind this is that even if the market was flat and inflation was not a thing you can withdraw 5 percent a year safely for 20 years, but not for 21+ years.

However many people cite how the market returns money every year and you could live off the returns, but this doesn’t always workout. Recessions are a fact of life and when they hit they tend to hit hard. In the most recent recession the S&P 500 took over a 50% dip from there all time highs. So imagine if your cost of living was $40,000 a year and you retired with $1,000,000 right before the recession. You would have essentially retired with half of that at the bottom of the recession and until the economy recovered in 2012 you would have to keep selling your stocks in order to pay for your basic expenses, which are now 8% of your portfolio. By the time the economy recovered you would have already had to sell some of your shares at an all time low in order to pay for basic expenses leaving you with a lower principal to withdraw from for the rest of your retirement. If you aren’t able to go back to work or lower your living expenses you will run out of money.

The learning experience about payout period is that you should plan for some recessions if you want a longer payout. You should plan to be able to lower your living expenses during recession to preserve as much capital as possible leaving your portfolio the best chance to recover. At the time of writing the S&P 500 has tripled since the 2009 lows and if you managed to preserve your principal during that time you would be well off. One proponent of this financial planning is Warren Buffett when he goes to McDonald’s every morning:

WARREN BUFFETT’S Daily routine 2018

He keeps one of following as exact change for breakfast:

This is an example of a person worth $80 billion saving 50 cents on breakfast when the market is down to preserve his capital.

Portfolio Composition

What we find with portfolio composition is that a good mix of stocks and bonds does the best at providing successful safe withdrawal. Let’s focus on the extreme portfolio compositions in order to learn from them.

One extreme portfolio composition is to have 100% stocks. The con of this approach is that regardless of the payout period there are only a few withdrawal rates that lead to success. The reason for this is that stocks are very volatile and one bad recession could wipe you out. The pro though is that if you want to have a short, but high withdrawal rate retirement the all stocks portfolio is your safest best. This is because stocks have the best chance of yielding high returns.

Another extreme is having all bonds. In this extreme the portfolio is more successful for low withdrawal rates. This is due to the nature of bonds being consistent small returns. The main con of this approach is that the bond fund has no chance of supporting a high withdrawal rate retirement. This is because most bonds are designed to barely beat inflation and can not possible sustain a 10+% withdrawal rate retirement.

Thus our focus shifts to the best of both worlds where the portfolio has a good mix of stocks and bonds. The tables seems to suggest that 25% stocks and 75% bonds is the safest allocation. Safe being that it can sustain a small withdrawal rate with the highest probability of success. This supports the age old wisdom of “having 1% bonds for every year of age”, since the average age of retirement in the US is 65. One reason this portfolio blends works out so well is that you get diversification of assets. Part of your portfolio will be in stocks that have high risk, but high returns. That risk can then be hedged with bonds that are low risk, but low returns.

Diversification is always good, but I think a less stated benefit of a blended portfolio is that is allows an investor to perform the the first and only rule of investing:

“Buy Low. Sell High”

Having a fixed allocation of stocks and bonds means you are mathematically going to have to sell stocks and buy bonds when the stock market is up (thus locking in gains). And the reverse is true where you going to have to sell bonds and buy stocks when the stock market is down (buying stocks at a discount). So with those two things put together you are “buying low and selling high”.

Withdrawal Rate

I do not think there is much to take away from the withdrawal rate in the table, since it’s a mathematical side effect. The higher your withdrawal rate the less safely you can withdraw regardless of the payout period and portfolio composition. So unlike the other two factors I do not have take away lessons.

Conclusions And After Thoughts

You want to plan for your financial independence and retirement, but this isn’t a “set it and forget it” strategy. The takeaway isn’t “Oh just put aside 25 times my yearly expenses and then you should be good”. Recessions do happen and you should be prepared for them. Two ways to be prepared as mentioned in earlier sections:

If you want to be extra safe you can have two costs of living:

And to be safe have 25 times the more expensive lifestyle.

One note about the study and why “past performance is not indicative of future results” is that the data stops at 1995. Even though the table has almost 70 years of data it does not have data from two large recessions that happened in recent history:

A chart of the S&P 500 will show how the last two decades of stock market trading has never happened before in the history of the stock market:

S&P 500 Chart

Credit

As we can see the stock market had very minor boom and bust cycles from 1950 to 1995, but only recently in the 21st century have we had such massive swings in the stock market. Never before have we seen 200% gains followed by 50% loses over a 5 year period in the stock market. There is even evidence of bubbles that will come up in the near future. Student loan and healthcare are just some on people’s radars. This just shows that the historical data from the paper was collected from a financial landscape that doesn’t exist today. Another outdated part of the paper is that bonds are much less in favor today, then they were 20 years ago. These factors are things everyone will just have to account for in their “personal” finance journey and no one article is going to have a strategy that works for all future financial scenarios. The best we can do is learn for the past, figure out what worked, apply some of those strategies to today, and see what changes we need to make for tomorrow.

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Email: bschong2@illinois.edu

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