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Feature Portfolio Strategies Retirement Planning

Solving the Problem of Retirement

Retirement places potentially unlimited demands on finite savings, but there are three actions investors can take to mitigate the problem.

by Paul Merriman | July 2017

Paul Merriman leads a class in AAII's new Essential Investing Video Course. Go to https://www.aaii.com/ves for more information and to subscribe.

For many people, retirement is a wonderful, fulfilling time when they’re finally relieved of many pressures and struggles that may have dominated their life.

But retirement is often a problem for those who have not saved enough to live comfortably. For many people in their 50s and 60s, that problem suddenly looms large as they are forced to confront a variety of realities.

They may have inadequate savings. They may have unanticipated responsibilities caring for family members or paying large medical bills.

If you’re wondering what I have to say about this, in a nutshell here’s a “spoiler alert:” There’s no magic bullet. But if you do a few things diligently and well, you can probably solve what I call “the problem of retirement.”

The Problem

The problem of retirement is essentially that life can place potentially unlimited demands on your finite life savings. As a result, it can be very hard to know when you have enough savings in order to “safely” retire.

In this article, I tell you the best ways I know to address this problem.

A decade or two ago, many advisers and financial experts believed and taught that a retiree could safely withdraw 5% of their investment portfolio every year without much risk of running out of money. In recent years, I’ve met very few people who wouldn’t be satisfied with that formula. If you have $1 million when you retire, you could take out $50,000 a year for living expenses. (For the sake of convenience, I assume for the rest of this discussion that we’re talking about a retiree with $1 million, even though many people have more and many others have less.)

Furthermore, the thinking went, investment returns were likely to at least keep up with inflation. That meant you could withdraw $50,000 in the first year and adjust that number upward every year for actual inflation. As it turns out, the success of that scenario depends largely on the luck of inflation and of market returns during the first few years of your retirement—neither of which can be foreseen. If this luck turns against you, you could be in real trouble.

To see how real this trouble is, take a look at Table 1, which tracks what would have happened to somebody who retired in 1970, invested solely in the S&P 500 index and followed this formula. The startling news is that, after 10 years of retirement, the numbers show that you were locked into an unpleasant race to see which would run out first: your money or your life.

Table 1. Moderate S&P 500 Fixed 5% Distribution Schedule

Retirement starts with an initial investment value of $1 million. Fixed initial withdrawals (5% of initial portfolio balance) are adjusted each year for inflation, with distributions taken at the start of the year. The results reflect Fine Tuning Table returns (published in the online version of my June AAII Journal article, “Power Your Portfolio With Value”) and no management fees.
Year Total Portfolio Value ($) Annual Distribution ($) Inflation** (%)
100% Bonds 40% Stocks/ 
60% Bonds		 50% Stocks/ 50% Bonds 60% Stocks/ 40% Bonds 100% Stocks*
1970 1,090,624 1,051,897 1,041,644 1,031,176 988,247 50,000 5.48
1975 1,135,046 1,028,374 997,868 966,085 834,952 68,807 7.01
1980 1,013,902 1,036,038 1,028,998 1,016,590 929,399 101,819 12.41
1985 1,021,187 1,039,828 1,016,594 981,494 762,013 139,834 3.77
1990 558,214 704,100 689,993 651,943 320,550 167,444 6.10
1992 273,987 489,580 479,662 437,215 3,572 183,111 3.03
1993 93,610 330,576 319,760 273,177 — 188,660 2.75
1994 — 134,830 124,723 78,928 — 193,854 2.67
1995 — — — — — na na
*S&P 500 index.
**As measured by consumer price index (CPI).

 

At the end of 1979, after just a decade of supposedly carefree retirement, your $1 million portfolio would have been worth only $803,741. At the start of 1980, you would have needed to withdraw $101,819, or 12.7% of your portfolio, just to meet your cost of living ($50,000 in 1970 dollars).

You can see from the dashes toward the bottom of this table that this course of action would have reduced your portfolio to less than $4,000 by the end of 1992. The other columns in the table indicate you could have prolonged the agony by another couple of years if you had kept 40% to 60% of your portfolio in fixed-income funds. The ultimate outcome would have still been the same: By the mid-1990s, you would have been broke.

These days, the standard withdrawal advice has shifted from 5% to 4%. (Many advisers are recommending withdrawals as low as 3%).

To see how 4% withdrawals would have worked, take a look at Table 2, which presumes that you could afford to live on a $40,000 withdrawal your first year in retirement. At first glance, this table looks much better.

Table 2. Conservative S&P 500 Fixed 4% Distribution Schedule

Retirement starts with an initial investment value of $1 million. Fixed initial withdrawals (4% of initial portfolio balance) are adjusted each year for inflation, with distributions taken at the start of the year. The results reflect Fine Tuning Table returns (published in the online version of my June AAII Journal article, “Power Your Portfolio With Value”) and no management fees.
Year Total Portfolio Value ($) Annual Distribution ($) Inflation** (%)
100% Bonds 40% Stocks/ 
60% Bonds		 50% Stocks/
50% Bonds		 60% Stocks/
40% Bonds		 100% Stocks*
1970 1,102,104 1,062,969 1,052,609 1,042,030 998,650 40,000 5.48
1975 1,221,648 1,111,483 1,079,964 1,047,122 911,627 55,046 7.01
1980 1,230,088 1,279,661 1,279,194 1,273,215 1,211,615 81,455 12.41
1985 1,641,507 1,728,416 1,720,820 1,700,661 1,539,525 111,867 3.77
1990 1,711,535 2,076,084 2,113,576 2,125,027 1,981,777 133,955 6.1
1995 1,659,065 2,597,462 2,766,812 2,894,185 3,054,766 159,225 2.67
2000 1,164,929 3,234,061 3,761,669 4,252,151 5,790,356 179,221 3.38
2005 448,346 2,828,407 3,352,851 3,797,623 4,810,664 202,658 3.42
2010 — 2,265,460 2,864,665 3,341,187 4,149,511 230,001 1.5
2015 — 1,655,413 2,618,486 3,482,483 5,740,121 250,090 0.73
2016 — 1,485,726 2,529,208 3,485,142 6,144,608 251,910 2.07
*S&P 500 index.
**As measured by consumer price index (CPI).

 

The analysis used to construct these tables covers 47 years, considerably longer than the retirement span most people can expect. However, there’s a good chance that if you and your spouse retire at 65, at least one of you will still be around 30 years later at age 95. (Portfolios were halted if the balances fell to zero prior to the end of the 47-year period.)

Using that assumption, let’s look at the year 2000, after 30 years of retirement. For inflation-adjusted living expenses that year, you would need to withdraw $179,221 from a portfolio that ended 1999 with a value of $6.5 million. That’s a withdrawal rate of about 2.7%.

A piece of cake, right?

Well, not quite. In order to achieve that year-end portfolio value, you had to keep 100% of the portfolio allocated to stocks. Looking back now, we can see that was fine. For retirees in their 80s and 90s, 100% equities can seem pretty scary. You could have significantly reduced that risk by keeping half your portfolio in equities and half in fixed-income funds.

I think these returns may overstate the case of what we can expect in the future. The 1990s included an almost unprecedented boom in U.S. stock prices. Plus, bond prices in the 1980s and 1990s benefited from a very long decline in interest rates. There’s no way that could recur any time soon. So I’m not sure that the 4% rule, now widely quoted, is enough to solve “the retirement problem.”

Solving the Problem

What’s the answer? I propose three ways you can mitigate the problem. If you do as I have done with my own portfolio and put all three of them to work, you can effectively solve the problem. They are:

  • Diversify widely and sensibly beyond the mainstream U.S. stock market (represented by the S&P 500 index).
  • Adopt a flexible distribution system based on your portfolio value rather than a fixed inflation-adjusted budget set at the start of your retirement.
  • Before you retire, save considerably more money than you think you’ll need.

Diversify

For many years, I have advocated for the use of multiple asset classes in the asset part of most retirement portfolios.

Specifically, I recommend equal parts of U.S. large-cap blend stocks (like those in the S&P 500), U.S. large-cap value stocks, U.S. small-cap blend stocks, U.S. small-cap value stocks, U.S. real estate investment trusts (REITs), international large-cap blend stocks, international large-cap value stocks, international small-cap blend stocks, international small-cap value stocks and emerging markets stocks.

When you put together such a portfolio using low-cost index funds and exchange-traded funds (ETFs), the result is what I call the Ultimate Equity Portfolio. I described this combination in the June 2017 AAII Journal (“Power Your Portfolio With Value”).

This carefully constructed combination is designed to take advantage of the long-term higher expected returns from value stocks and small-cap stocks and the risk reduction you often get from investing outside the United States. Most of my own portfolio is based on this approach.

In our portrait of the person who retired in 1970, we assumed the portfolio was entirely in the S&P 500. Table 3 gives a comparison showing different results if you had invested in the Ultimate Equity Portfolio and took out $50,000 each year adjusted for inflation.

Table 3. Ultimate Equity Portfolio with 5% Withdrawal Rate

The Ultimate Equity Portfolio diversifies globally, by size and by valuation and includes real estate investment trusts (REITs). A 5% inflation-adjusted withdrawal rate is used.
  S&P 500  Ultimate Equity Portfolio
Portfolio value 12/31/79 $803,741 $1,632,626
Withdrawal for 1980 $101,819 $101,819
As percent of portfolio 12.67% 6.24%
Year you run out of money 1992 Probably never

 

Why the “probably never” in that last line of the table? Because at the end of 2016, the Ultimate Equity Portfolio was worth $28,738,813 and the distribution for 2016 was only $314,888, or about 1.1% of the portfolio. (And relatively few people who had retired in 1970 were still around at the end of 2016 anyway.) If by some miracle you were still living in 2017 and had investments worth $28 million, you probably would have felt quite comfortable about spending more than $314,888.

This leads me to my second suggestion for mitigating the retirement problem: taking flexible distributions instead of fixed ones.

Flexible Distributions

Our first scenario was based on a $1 million initial investment made in 1970 with a need for a $50,000 withdrawal in the first year. The withdrawal amount is then adjusted each year for inflation. When that portfolio was invested in the S&P 500, the long-term scenario was derailed by the unceasing increases in the required withdrawal.

In six of the first 12 years of this retirement scenario, inflation was above 8%. That could not have been predicted, but it’s always possible. Every year, inflation relentlessly drove up each required withdrawal, regardless of how the investments in the portfolio grew. Before too long, as we saw, the portfolio simply could not keep up.

There’s a better way to take money out during retirement, at least for those who can afford it. That is to adjust withdrawals depending on how your investments are doing. This is essentially what any smart investor would want to do: Take out a bit more when things are going well, and tighten his or her belt a bit when the investment portfolio is struggling.

Such a flexible distribution schedule can’t give you certainty in advance of how much you’ll have. In this period starting in 1970, it would have required some serious belt-tightening. In 1980, instead of taking out $101,819 from a portfolio invested in the S&P 500, our hypothetical retiree would have had to get by on only $52,917. This certainly presents a problem, which I’ll address shortly.

In the longer run, things got much better, as you can see in Table 4. By 1991, this portfolio did well enough that the distribution was up to $146,896, and it never got that low again. By the year 2000, the S&P 500 portfolio had done so well that the distribution was up to $509,053.

Table 4. 100% Stocks (S&P 500) Flexible 5% Distribution Schedule

Retirement starts with an initial investment value of $1 million. Flexible withdrawals based on 5% of initial portfolio balance are adjusted each year for inflation and market performance, with distributions taken at the start of the year. The results reflect Fine Tuning Table returns (published in the online version of my June AAII Journal article, “Power Your Portfolio With Value”) and no management fees.

Year-End Balance ($) Distribution ($) Cumulative Distribution ($)

Year
1970 988,247 50,000 50,000
1975 895,582 34,353 297,252
1980 1,331,264 52,917 541,128
1985 2,046,402 81,490 899,386
1990 2,937,919 159,581 1,519,319
1995 4,897,786 187,367 2,416,461
2000 8,791,336 509,053 4,261,558
2005 6,989,859 350,662 6,024,952
2010 6,057,318 277,070 7,651,915
2015 8,471,948 439,806 9,419,374
2016 9,010,943 423,597 9,842,972

 

When this flexible distribution plan was applied to the much more diversified Ultimate Equity Portfolio, the result was considerably better.

In 1980, a distribution of $93,995 was taken, much more than the $52,917 distribution from the S&P 500 portfolio. However, even with this combination of diversification and a flexible withdrawal schedule, there were some rough years in the 1970s to get through if you really needed $50,000 each year adjusted for inflation.

With fixed distributions, you didn’t have to worry about either inflation or your investment returns, at least for a while. In 1975, you took out $68,807. In 1978, you took out $82,409. Those withdrawals met the needs that you determined before you retired.

On the other hand, with flexible distributions, your income depended on how your investments were doing. Even though you had the benefit of worldwide diversification, in 1975, you could take out only $37,012. In 1978, your withdrawal was $68,580, still considerably less than the $82,409 that you needed.

Not until 1984, the 15th year of your retirement, would the flexible distribution catch up to your “needs.” (However, from that point forward your flexible distributions would have remained ahead of those from the fixed schedule.)

How many retirees are willing to undergo that much belt-tightening in order to wind up with more money to spend in their later years? Not many.

So, we are still stuck with “the problem of retirement.” Fortunately, there’s still a way to solve that problem.

Save More Than You Need

Admittedly, this final step is much easier for young people than it is for those in their 60s. Still, the math is undeniable: If you start with more, you can live further from “the edge.” If nothing else, you’ll have more resources to cover the emergencies and unexpected expenses that don’t stop coming your way just because you have retired.

Let me suggest a little math: If you really need $50,000 from your portfolio in your first year of retirement, a $1 million portfolio means you’re counting heavily on things going your way. This we have seen.

Now suppose you started with $1.5 million, still needing only $50,000. If you multiply the distribution figures by 1.5, you’ll see that your needs will be met, even in a tough decade like the 1970s, with a serious bear market (1973 and 1974) followed by some serious inflation (12.2% in 1974, 13.3% in 1979, 12.4% in 1980).

True, you would have had to tighten your belt a bit in a few years, but starting in 1978, you would have had a comfortable cushion above your needs. In addition, the flexible distribution schedule would ensure that your portfolio would always be larger than if you took fixed distributions.

Even better, after 10 or 12 years of retirement, you could have comfortably increased your withdrawals to a 6% rate.

For example, assume that you maintained a flexible distribution schedule and a properly diversified equity portfolio. Assume also that in 1982, you upped your withdrawal rate to 6%. In that year, you would have been able to spend $141,528. That compares with your “need” that year for $74,811. And things just continued to get better from that point forward.

This three-way combination of diversification, flexible distributions and over-saving adds up to what I have described elsewhere as “The ultimate retirement withdrawal strategy.”

The steps you need to take to over-save are not complicated.

  • Tighten your belt a bit in your peak earning years to set aside more money (and incidentally get in the habit of living a bit below your means).
  • Plan to work a few years longer before you retire. This has the double benefit of boosting your savings while reducing the number of years your portfolio has to “pay you” in retirement.
  • If you can, find a way to work part-time for the first few years of “retirement” so you postpone the full weight of distributions you will need.

Not everybody can do these things, of course. Plus, no matter what you do, the “luck” of the unexpected can always interfere with your plans.

Yet with these simple steps, you can come as close as possible to Solving the Problem of Retirement. I hope you’ll do so.

Richard Buck contributed to this article.

Discussion

Richard Wiwi from CA posted over 9 years ago:

Paul, I found your article in the recent issue of AAII as well as the article above of great interest. So I decided to test your approach (including using your published return figures for the "Ultimate Value" portfolio) with my proprietary modeling technology. Result: with a sophisticated (unique) modeling tool that can address multiple financial inputs, i.e inflation, taxes on withdrawals, uncertainty in asset valuations, variable and fixed expenses,longevity risk and more, all interacting SIMULTANEOUSLY through time as in a real life scenario, you fall short of solving the retirement problem--more than 70% of the time. So while this approach adds to the understanding of the problem, the conclusions and advice are more dis-information and, perhaps, downright harmful (unintentionally of course) than sound and wise. In all fairness, this subject requires more treatment than this space permits.


Herb Schrayshuen from NY posted over 9 years ago:

Richard Wiwi should show us his analysis. Post it and send us the link.


Curtis Wheeler from HI posted over 9 years ago:

Yes, I agree that showing Mr. Wiwi's analysis would be of value to the discussion of having enough for retirement.


David Michaels from NC posted over 9 years ago:

As my wife is considerably younger than me, I have been struggling with this [potential] problem for several years in my planning. The best solution seems to be, 1) keep current expenses to a minimum so you will be able to start at that rate of withdrawal, 2)save far more than you think you need and, 3)stay healthy to prevent those costs from taking away your portfolio and the income it can produce. No plan can cover everything in retirement just as has happened in our lives to date. When I was younger a person could have lived with no worries on $40,000. a year. Thank you for these articles which help people plan the best they can.


Michael Murray from VA posted over 9 years ago:

From what I've read real return on assets, like stocks, is pegged at 2% for 5 to 10 years. This is very concerning, especially since most of the retirement analysis websites use historical returns. That said, rules of thumb, and guesstimates, are really a waste of time IMHO. You need to your expenses, and inflation, plus health care inflation to be even close to determining your income needs. GIGO! Garbage In, Garbage Out, is a saying we have in IT. Cheers


D Wilson from FL posted over 9 years ago:

I am having difficulty calculating the flexible distribution factor. I understand the 1980 withdrawal of $101,819 for the S&P 500 portfolio. But how was the flexible distribution withdrawal of $52,917 calculated? Presumably 1980 was not the first year of reduced withdrawals, which would result in a year end 1979 balance of more than $803,741. If with flexible distributions, the year end 1979 portfolio value was $1,058,340, then I understand that the flexible distribution can not exceed 5% of the previous year end portfolio value.


Doug Bell from IA posted over 9 years ago:

I agree with your flexible distribution strategy. Your diversification strategy is based on data that may not be relevant any longer. For example it speaks to diversification through various large cap, small caps, etc and world wide regions. The secret to true diversification is investing in uncorrelated investments. In today's world is difficult to find uncorrelated markets by investing as you suggest. Driven primarily by the ETF craze. I believe the ETF craze has actually increased the risks of stocks because of over weighting in technology stocks. For diversification to work the correlation should be 0.6 or less. In today's world the correlation between US stock and world stocks is ~0.8 to 0.9. Thus reducing diversification and adding risk.


Robert McGreevy from CA posted over 9 years ago:

I agree that Mr. Wiwi's information should be made available. Don't know how he could do that in this format. I for one would find it very interesting. I have been following Paul for 5+ years. On his website is a wealth of information and history. It will take someone a few days to weeks to assimilate it. Then, of course, there will be some that has to check into all of his analysis. That will take longer. When I first became aware of Paul, I thought he did an astounding job of putting all of this together. I still do. He has year by year returns and withdrawals for mutiple distribution schedules. I spent 6+ months analyzing his infomation and never really finished. He also gives his fund selections with years that were used. As time goes on, the investments change due to assorted things like fund closings, opening new ones, changing investment landscape etc. I don't think Paul's approach(es) gave him justice here due to lack of space in this article. I'm sure he could have gone on and on and on. I suggest his website to find more information. This is a great start...again.


John Lambert from NJ posted over 9 years ago:

"The problem" is that the 4% withdraw rule fails approximately 15% of the time historically. This occurs during times of high inflation and low stock market returns. Primarily retirement periods that included the 1970's and 1940's. I agree with Paul Merriman that diversification and increased saving can ameliorate some of "the problem". One other partial solution is inflation protection. This could involve owning a home, social security which is indexed, or investing in TIPS, REITs, or commodities. Flexible withdrawals are a solution if one doesn't mind periods of "bread and water".


Edward Kmiec from NJ posted over 8 years ago:

The only solution is to retire with all the money you will need in retirement. If you don;t have enough, keep working.


Richard Waters from MA posted over 8 years ago:

The tables all show 100% of the retirement funds at market risk and that a bear market early in retirement will be a particular problem. Why not keep 3 years of distributions in a money market to avoid selling investments in a bear market. This should solve the order of returns problem and allow agressive investing with the remaining funds. The article assumes selling assets prorata regardless of the market and no cash reserve. Would anybody do that?


Bruce Weber from PA posted over 8 years ago:

In addition to the recommendation of Richard Waters, I am looking at the value of dividend income to reduce risk of having to sell in a bear market. A dividend return of 3% means less equity selling each year for to achieve the 5% withdrawal. The other challenging consideration is retention of base retirement account value. The premise of the article is to achieve indefinite retention of the base account value. When is it safe to consider account value reduction and still have enough income for life? In the article example, The $1,000,000 portfolio will provide 20 years of income at 0% portfolio return (ignoring inflation increases). Since none of us knows our full life expectency, this leaves an unknown for the duration needed.


Robert Newell from HI posted over 8 years ago:

Mr. Merriman posts concrete analysis and specific examples. Mr. Wiwi refers to his proprietary models, says Mr. Merriman is wrong, but merely makes a flat assertion with nothing visible to back this up. He then says Mr. Merriman is providing "dis-information." I cannot speak to who is objectively correct here, but I can certainly say who, based on evidence presented, I would trust most.


Craig Conrad from NC posted over 7 years ago:

I retired nearly 3 years ago at 59. We had (and have) no debt, and a modest fixed pension. My wife is working half-time at a modest salary, and I also work about half-time for a family member at a modest salary. We have determined to live off my pension and my part-time income, placing 100% of my wife's income into her 401K plan. While we are living comfortable, but modest, we have not yet touched our Roth or 401K accounts at all. Our plan/target is to continue this until I hit Full Retirement Age (FRA) for Social Security at 66+. That will be a big boost to our income and lifestyle and will likely allow us to continue leaving our retirement funds alone (growing without drawing) for additional time. Further, if and when we *do* begin using those funds, I hope to annually withdraw the SMALLER of: (a) 4% and (b) the "need". So, my advice to add to this excellent article: (a) retire after clearing all debt; and (b) follow "flexible distributions", but even in the "good" years, don't take more than your "need" ...


Anthony Tuk from North Carolina posted over 6 years ago:

Retired 18 years ago and have about the same amount of capital I started when I retired. The focus only on the income stream is good but incomplete. Many of the comments also focus on the withdrawal stream by reducing fixed expenses during preretirement (mortgage debt, loans etc) Also to have a short term invesements for 3-4 years separated from your variable investment portfolio has worked for me exceptionally well in avoiding too much anxiety during the crisis years I experienced (2001-2002, 2007-2009....)and allowed me to have funds available during market recovery to invest. The approach has to be multifaceted to succeed. Simple example:long term care insurance a good idea... Control of the impulse factor is the most important "investment" both on the income stream and the expenditure stream.


Kevin from California posted over 6 years ago:

Turns out I am retiring next week at age 58 - about 6 months sooner than I thought last month and probably 18 months sooner than I was shooting for just a couple years ago. Working would have definitely helped with the cushion, but the reality is saving another $100k only translates into about $4k of extra cash flow. Seems reducing the expense ledger by $4k works just as well, and doesn't represent too much of a lifestyle impingement.


Peter from NJ posted over 6 years ago:

Interesting Article. It would be helpful if we could see the correlation between the asset classes. As it may help with my step 3. An alternative I am investigating is to have multiple investing "buckets" by process. Step 1. Break your retirement budget into "Needs", "Wants", "Savings". Step 2. Identify "safe" funding of the "needs". Such as a 6 year bond ladder (adjust number of years to your risk tolerance), Annuity, 50% of SS, Dividend growth portfolio which oversupplies your required income by 20% (roughly the drop in dividend income after 2009.. you would need to adjust the overfunding % for your portfolio) Step 3. Set up a traditional portfolio for the rest. Many years to go before I retire but seems to feel logically correct and the math works assuming I can stay on plan. Just additional food for thought. Feedback from those with more experience welcome.


Ronaldo from MD posted over 6 years ago:

I really appreciate this article which points out the fallacy being posed by most of the financial planning industry. This article show that the 5% or 4% or even 3% simple distribution formula does not provide the security sought by most retirees. Remember when you retire you are typically at your peak earnings level and most of the obligations (e.g., child expenses, mortgage) are at a minimum. There are increases in health costs that will happen regardless whether you retire or not. So the question is what to do with the remainder of your life (~10% to 33%)? Perhaps you can work part-time? Transition to a job you will would really love to do? Move to where you kids/ grandkids are located and set up a joint living/cost-sharing arrangement? The possibilities are endless. The bottom line of the article for me is that the passive investment approach is a losing proposition and I will need to actively managed my portfolio to increase the likelihood my money will not run out.


Joe from OH posted over 6 years ago:

Maybe I missed it, but I did not see any explanation in the article on how to calculate the flexible distribution amount. All I saw is that you take inflation and portfolio value into account, with no exact formula provided.


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