Let me start this post off by saying that this idea isn’t for everyone. Some retirees are comfortable spending down their assets during retirement and would therefore find this idea to be way too conservative. I’m not necessarily against spending down assets, but I do think it is important to exercise caution because future income is dependent upon the asset base (also called a capital base). The smaller the base, the smaller the income.
As long-time readers probably know, I have been tracking a few model portfolios over the last several years. With 2007 coming to a close, I have been updating the portfolios over the last couple of days. These portfolios consist solely of exchange-traded funds. Unfortunately, the exchange-traded funds in the portfolios have only been around since mid-2001 (some of the ETFs are even newer than that). Such a short history makes it difficult to really judge the prudence of a strategy. So,… this year I went back and assembled a hypothetical portfolio going back as far as I could using index data. I then organized the annual returns into the following table and then computed the annual returns of the portfolio based on the allocation. Here’s the annual results since 1992:
This particular portfolio is allocated 50-50 between stocks (both domestic and international) and bonds. I think this allocation is both conservative and worthy of consideration for a retirement portfolio. Notice the returns for the years beginning in 2004 are shaded grey. Those years represent the returns for the actual exchange-traded funds that represent those asset classes (the bond class is represented by equal parts in the iShares Lehman Brothers Aggregate Bond Index Fund (AGG) and the iBoxx $ Investment Grade Corporate Bond Fund (LQD)).
After I assembled the above table of returns, I was able to run scenarios using different withdrawal rates, assuming a beginning retirement balance of $1,000,000. The results were interesting. For example, take a look at what happens with a 5% withdrawal rate:
In order to make this hypothetical as realistic as possible, I assumed that the index returns had management expenses of .48%, which is equivalent of most of the iShares ETFs used in the portfolio. I also assumed portfolio management expenses, which include both a FOLIOfn advisor fee and an advisor fee. A do-it-yourselfer could definitely reduce those expenses if they wanted to handle their account on their own.
Anyway, notice how the initial withdrawal was $50,000 at the beginning of 1992 and $69,079 at the beginning of 2007 for an average annual increase of 2.18%*, which did not keep pace with inflation. Also note that the asset base grew from $1,000,000 to $1,411,799 at the close of 2007.
Now, what happens if we adjust the withdrawal rate to 4%?
Agreeing to withdraw a smaller amount each year, makes a sizeable difference over the years:
So, although the initial withdrawal was $10,000 less in 1992, it was only about $5,000 less at the beginning of 2007. Why is this so? Because a smaller withdrawal rate left more money to compound over the years. The retirement balance at the end of 2007 was $258,818 higher under the 4% withdrawal strategy.
What’s the point of all this?
I think this example shows that if you can afford to withdraw less from your retirement account, you should (at least in the beginning). You can always take out a greater percentage later if the need arises. On the other hand, if your goal is to spend down your assets during retirement, you can ignore this post. Just remember that once it’s gone, it’s gone.
*Calculated using the following formula:
[($69,079 ÷ $50,000)1/15] – 1