Retirement Planning

How much money do I need?

The most important part of any financial plan is to determine the amount of money you need after you stop working. Unfortunately, this is where most people make the biggest mistakes.

Most people assume unrealistic rates of return and misunderstand the risk associated with the return rates used. Data for US markets exist back to 1926. Just because US stocks have an average return of about 10% since then does not mean that is an appropriate rate of return to use for retirement planning. Stocks can be volatile and the majority of stock returns tend to come in concentrated increments of time. Click here to see what happens if you miss the best days.

It is possible that you will have extended periods of time where actual returns are nowhere near the average. If you base your return assumptions off of historical stock return averages, you are likely to be disappointed. These average stock returns have variability around the average which can be measured by the standard deviation of the yearly returns. The variability (standard deviation) of stock returns is much greater than for other asset classes such as bonds and cash. That makes stocks poor investments for retirement planning. Unfortunately, stock returns are what most people use. Your retirement plan is not likely to be a successful one if you cannot count on the reliability of the returns you assume. Click here to see why the volatility of your portfolio matters.

Stock returns vary considerably over time making them a poor choice for retirement planning. Unfortunately most people use stock returns when planning for retirement. Often, people think they can make up for an under funded nest egg by increasing the risk (percentage of stocks) in their portfolio. This is a big mistake!

Let’s look at a recent historical example. From 2000-2009, stocks (S&P 500) had an average return of 1% with a standard deviation of 21. From this data, you can interpret that 95% of the time (2 standard deviations), you could expect a return of somewhere between -20% and 22% in any given year. If you were to graph that kind of uncertainty year over year for a 20 year period, it would look like this:

Figure 1 shows what an investor with $2 million dollars can expect over a 20 year period if he withdrawals $100,000 per year (a 5% withdrawal rate). As Figure 1 shows, you would have a 95% certainty of falling somewhere between being broke in 8 years or having $2.9 million after year 20. This is a very large range of possible outcomes, and is hardly the kind of certainty you should aim for in your retirement plan.

Now let’s look at an example of what the same investor could expect if he invested $2 million dollars in a globally diversified portfolio of 30% stocks and 70% bonds. During that same period, Portfolio 30 had an average return of 4% with a standard deviation of 6. From this data, you can interpret that 95% of the time (2 standard deviations), you could expect a return of somewhere between -8% and 16% in any given year. If you were to graph that kind of uncertainty year over year for a 20 year period, it would look like this:

Figure 2 shows what an investor with $2 million dollars can expect over a 20 year period if he withdrawals $100,000 per year (a 5% withdrawal rate). As Figure 2 shows, you would have a 95% certainty of having an ending balance somewhere between $400,000 and $2.9 million. This is still quite a range, but note that all possible outcomes fall above $0 which means you don’t run out of money.

You can interpret two important points from the examples above:

Stocks add additional risk (uncertainty)
That additional risk (uncertainty) only gets larger with time

We use 2 standard deviations in our examples above, because 2 standard deviations cover 95% of possible outcomes - which means you can plan your retirement with 95% certainty. For those who think 95% certainty is too conservative, it would be wise to note that 2008 was actually a 4 standard deviation year. In retirement planning, aggressive assumptions will ultimately lead to disappointment.

There is no denying that a higher concentration of stocks could leave you with more money. However, the primary goal in retirement should be to make certain you do not run out of money, not see how fast you can double your portfolio.

Since it is impossible to predict when down years will come and how many down cycles you may experience throughout retirement, it makes sense to invest the retirement monies you know you will need in a less volatile portfolio. We believe the right mix is a globally diversified portfolio of 30% stocks and 70% bonds. The 30% stocks give you the edge you need to keep up with or slightly outpace inflation while the 70% bonds give you the stability needed for retirement income. Click here to see the returns and standard deviations of our investment models.

Once you have the amount of money you need invested in a 30/70 portfolio, you can invest your excess monies more aggressively. It is OK to reach for higher returns with your excess monies, but we do not think it is wise to do so with the money you know you need b/c the added uncertainty outweighs the potential benefit of higher returns. We believe the primary retirement goal should be to meet your objectives without running out of money. Introducing the possibility that you run out of money so you can say you had a higher average return seems illogical.

But I thought stocks always outperform over the long run…

Often people will justify a larger stock allocation by saying they are long term investors and that stocks beat all other investment classes over the long haul. That may be true over a 50 year period, but most people are not retired for 50 years. The average retirement age in the US is 65 and the average life expectancy is 80 years. Fifteen years is a rather short period of time and few retirees have the emotional stamina to withstand a 50% drop in their nest egg once they stop working.

The key to a successful retirement plan is to make sure that your return assumptions are appropriate and that your assets are actually allocated as your plan assumes. Don’t make the mistake in thinking you can achieve the average stock market return without taking a considerable amount of risk – even though many professionals will lead you to believe you can do just that. The truth is most investors fall woefully short in achieving stock market returns even though they are invested in stocks. Studies show that the average investor achieves less than half of what markets do over time.

An independent research group, DALBAR, has repeatedly shown that broker-advised and self-advised investors dramatically underperform the advertised returns of their underlying mutual fund holdings as well as the S&P 500 Index. In their recent study (January 1989 thru December 2008) they found that the average equity investor earned an annual return of 1.87% compared to the S&P 500’s return of 8.35% over that same time period. Trading in and out of mutual funds caused investors to end up with less than 25% of the return they would have achieved thru a buy and hold strategy.

Uncertainties are all around us, and you can never avoid all risks. However, it is possible to create a retirement plan that removes many of those risks and uncertainties. At Performance Investment Group, we focus on creating retirement plans that have a high degree of certainty. We believe it is unwise to take unnecessary risks with the funds you have and know you will need. Our philosophy is to invest the money you will need in a low risk globally diversified portfolio. If you have excess monies, then we will invest the remainder in a portfolio that matches your risk preferences.

Graph notes
S&P: 1.09% ROR; 21.13 Std Dev
Portfolio 30: 4.23% ROR; 6.21% Std Dev