Friday, 18 October 2019

The Simplest Retirement Planning

Retirement Plan

There are a lot of complex strategies out there when it comes to withdrawing your money in retirement. But not all strategies have to be complicated to work well. Sometimes this simplest strategy is the most brilliant of all. And today that is what we are going to talk about.

We are going to be talking about two of the simplest retirement withdrawal strategies out there, discuss their pros and cons, as well as discussing who should be using them. 

Lets Gets Started.

The strategies that we are going to be covered today are very similar to one another, in that they are both know as fixed withdrawal strategies. They are 


  • The Fixed Dollar Withdrawal Strategy 
  • The Fixed Percentage Withdrawal Strategy

Let's start with the simpler of the two


The Fixed Dollar Strategy

The fixed dollar withdrawal strategy is exactly what it sounds like, you being by withdrawing a certain dollar amount from your invested every single month and keep that amount constant throughout your entire retirement.

Let's say John has a $1,000,000 invested and wants to live on $40,000 a year, he withdraws $40,000 in the first year of retirement, does the same thing in the second year, and so on. 

In other words, there are no adjustments for inflation using this method.


The 4 Factors

To analyze this strategy, let look at the 4 factors of retirement which for those who are new to this website.
  • Income
  • Risk
  • Stability
  • Buying power.

Income: This is measured by how much money is coming in each month or year as well as when that money is coming in. It's measured this way because not all retirement spending strategies are systematic and linear with their income growth, and since none of us know how long we are going to be in retirement, so we tend to put more of a priority in having abnormally high-income years in the earliest portion of our retirement. 

Risk: Is the likelihood of outliving your money. 

Stability: is graded by how often you experience anything that would be considered an undesirable change in your income from year to year. This could come in the form of a freeze on the growth of your income or a decline in your income from one year to next.

Buying power: It is defined just like always is, by measuring what your money can actually get you at any given time and is largely tied in inflation.

The Fixed Dollar Strategy

The fixed dollar strategy is generally considered to be a little stronger on the income and risk, in comparison to other popular strategies like the 4% rule, but it does suffer a little more in the stability and buying power categories.

The reason for this is that, as long as your initial withdrawal are not too high, you are relatively unlikely to outlive your money using this strategy, and you may be able to live at a higher standard of living, at least initially, than you would have in other similar strategies like the 4% rule.
  • In fact, going all the way back to 1950, and looking all the way to October of 2019, which is the most recent data I have at the time of this writing if john as had that $1,000,000 invested in something like the S&P 500, he would not actually outlive his money during any 20, 30, 40, or 50-year retirement, as long as he withdraw no more than $54,000 a year or $4,500 a month.

As I said, this initiative will give him a higher standard of living, than the 4% rule. Because with the $1,000,000 invested. The 4% rule would only allow him to withdraw $40,000 a year to live on.

Though eventually, the inflation effect would catch up with him, using the fixed dollar approach. 


Were The Fixed Dollar Falls Short

That is where this strategy tends to fall short. It is not meant for longer retirements. 

Because while John might be able to handle living on $54,000 a year, particularly if he retiring debt-free with a paid-off home, it becomes increasingly difficult to do that as the years go on due to the inflation effect.

Inflation has historically average somewhere between 2% and 3% per year in the U.S. If we assume that our personal average inflation rate in retirement is nearer the top of that scale at 3% per year, then john's $54,000 a year income will get him the equivalent of what $40,000 would buy him today in just 10 years time! 


  • Buying Power Of $54k
  1. 10 Years: $40,000
  2. 20 Years: $29,900
  3. 30 Years: $22,250
  4. 40 Years: $16,550
  5. 50 Years: $12,300

In 20 years his money would be able to buy him about what $29,900 would buy him today. And his money would be worth the equivalent of $22,250, $16,550 and $12,300 in 30, 40, and 50 years respectively. Just because of the affected inflation.

Imagine that john had decided to follow the financially independent retired early movement, but instead of using the 4% rule which helps protect your buying power over longer retirements, john decided to use the fixed dollar withdrawal method.

Assuming everything else stays the same, john will retire at the age of 30 with a $54,000 a year income and $1,000,000 invested. Again at the age of 30, that would be perfectly fine for him. However, the average life expectancy for people living in the U.S. is about 79 years old as of 2019. And it's possible that number will continue to grow as technology and medicine continue to advance.

Assuming john doesn't die young, it's not of the question that he would have a near 50-year retirement and be living on the equivalent of about $1,000 a month when his medical costs are at their highest. As you can imagine, that wouldn't be an ideal situation for john, that is why this strategy generally isn't the best idea for longer-term retirements.


3. Fixed Percentage Age

The fixed percentage method works every similar to the fixed dollar method, except that you are withdrawing a certain percentage of your invested every year as opposed to a certain dollar value.

This strategy also doesn't adjust for inflation, but it does at least adjust with the value of your portfolio and depending on what you invested in and what initial percentage you choose to withdraw, this method may work out alright.


The Fixed Percentage Age Method In Action

Say john wanted to withdraw 4% of his investments each year in retirement. Since this value of his investments was $1,000,000 when he retired, he would withdraw $40,000 in the first year. That would leave him with $960,000 leftover.

If his investments went up by 10% that year, the value of his portfolio would be somewhere in the neighborhood of $1,056,000 at the start of his second year of retirement. Since he withdrawing 4% of that, he would leave on $42,240.


  • Year 1: $1,000,000 - $40,000 = $960,000, + 10% = $1,056,000
  • Year 2: $1,056,000 - $42,240 = $1,013,760 - 20% = $811,008

The downside is that the reverse can also happen. Say that the following year john investments fell by 20%, bringing the value of the invested down to about $811,008, and forcing him to withdraw $33,440 in the third year of his retirement.

That would be significantly less than the $42,400 that john would've withdrawn in that third year using the 4% rule. 

As you can see depending on the situation, "stability" is something that this strategy could have a very low score in. (if it's invested in something like stocks) can grow or drop by 20%, 30%, or even 40% from year to the next.

The bright side is that you have a very low risk of running out of money. 


Examining The Bright Side:

Say if john had $10,000 invested and he wanted to live on 50% of his investment each year for the next 5 years...... In theory, he will be fine and will not run out of money because he will always be withdrawing 50% of whatever that investment is. But how many of us are going to able to live on $5,000 a year.

That would be what he would be withdrawing for the first year, and of course, it would be even less in the second year, if his investment stays flat, his second withdraw would be half of $5,000, or $2,500.

But the point is, if you are willing to take the hit to the stability of your income in retirement, you can usually safely squeeze out a little more than 4% of your invested each year in a typical retirement using this strategy.

You just have to be prepared to see the average raw dollar income that you receive dropped, as you go further into retirement.


Examining The Bright Side (Continued):

To illustrate this
  1. 20 & 30 year retirement (since 1950): Median income (monthly): $6,500
  2. 50 year retirement (since 1950) - Median income (monthly): $4,400
  3. Final years: Median monthly income: $2,300
  4. Not adjusted for inflation

Let's say that john withdraw 10% of his invested each year, assuming he as that $1,000,000 invested, he would start out with a 6-figure income, however, if he ended up living longer than he planned on, he could eventually find himself living on what could only be generously described as shoestring budget.

For example, assuming john had invested in the S&P 500 since 1950, he would've had median monthly incomes of about $6,500 in 20 and 30 years retirements. (Which when adjusted for inflation would be about $3,600 a month in 20-year scenarios and $2,700 a month in 30-year scenarios).

But the number dropped quite a bit as the retirement got longer. For example, in a 50-year retirement, his average median monthly income was about $4,400. Which again doesn't sound bad, but when we look at the final few years worth of his monthly withdrawals, we find out that it is about $2,300 a month on average, which is considerably less than the 6-figure income he started with.

Of course, that $2,300 a month was what he was actually withdrawing almost 50 years from now. Once we adjust for inflation over that time, it may not even buy john what $1,000 a month would buy him today.

Similar to the fixed dollar withdraw, your buying power could be taking a significant hit if the initial percentage you are withdrawing, is set too high


The 4 Factors

Fixed percentage 

In summation, the fixed percentage method scores reasonably well, though not elite, when it comes to income. (particularly early in retirement) it does great in terms of risk (assuming you are not too aggressive with your initial percentage), but horrible with stability (due to fluctuations in the value of your invested), and below average in terms of buying power (Unless you are too aggressive with your withdraw). 

Risk 

Assuming you are not too aggressive with your withdraws.

Stability

Due to fluctuation in the value of your invested

Buying Power

Unless you are too aggressive with your withdraw, in which case it gets pretty bad over time


Who Should Use Fixed Strategy?

I believe there are very few people who should really be using these strategies as their primary method. It mainly limited to those with very short expected retirements, so that their buying power doesn't become too damaged over time. And even the ideally only to those who are also approaching retirement with little to no debt.

Because especially with the fixed percentage method you will often need to be flexible with your spending. But for those who aren't retiring early (and likely have no more than 9 or 10 years that they expect to be retired), have little to no debt to speak of, and want something very simple to follow when figuring out how much of their money they should withdraw each year, one of these strategies can work out well.

It gives you some advantages in income without significant increases in risk.

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