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What Happens if the First Years of Retirement Are Bad?
By JLP | April 22, 2008
Last week I received an email from a reader about my annuity posts. He wasn’t very happy with me because he didn’t think I was being fair to those who sell annuities. We ended up having a rather heated discussion via email that lasted over several days. Anyhow, his first email came with an Excel spreadsheet titled “The Impact of Poor Early Years.” He asked me what a person was supposed to do in a situation where the first three years of retirement had returns of -20%, -12%, and -8%.
Basically, he was trying to show me that the remedy for this situation was an annuity.
I’m not so sure. First off, let’s take a look at the scenario he’s talking about:
I’ll admit, this retiree’s timing was bad. However, something that really stands out to me is the fact that even when the market was bad, this particular retiree kept withdrawing $30,000 per year when their account couldn’t support such a withdrawal. By year three, their $30,000 withdrawal represented over 8% of their retirement balance.
This was the reader’s solution:
Not too bad. Basically this is a product that guarantees a 5% return per year. This retiree can count on $30,000 per year, every year. Over a 30 year retirement, a retiree would receive $900,000 in income and would have an ending balance of $500,342. Not too bad until you consider inflation.
Now take a look at what would have happened in this situation had they kept their withdrawals to just 5% of the balance:
The results aren’t as good under this scenario—mostly due to the returns chosen for this example. Over 30 years, this retiree would have been able to withdraw $712,446 and would have an ending balance of $666,287.
Finally, let’s take a look at what happens if you get an 8% average rate of return and only take out 5% per year:
Given that the Israelsen portfolio (I wrote about Dr. Israelsen’s portfolio a couple of months ago) had an average annual return of 11.53% over 37 years before fees, I think it is reasonable to expect an average of 8% per year over the long run. I don’t see this as shooting for the moon.
I think the thing to keep in mind when thinking about retirement is flexibility. A retiree needs to be flexible in their spending and be able to spend less when necessary. There’s no reason that a few down years at the beginning of retirement should doom a retiree’s future.
NOTE: If you haven’t read Dr. Israelsen’s article, I urge you to check it out. It’s a little dry, but the results are fascinating.
Topics: Investing, Retirement Planning | 16 Comments »
April 22nd, 2008 at 6:33 pm
I really agree with this. People who are retired should treat the income as if they are still working. If you work commission only at a job, some years are better than others. 1 year you might make say $100,000 after taxes, at year 2 you might only make $60,000. Do you spend your money in year 2 as you did in the first or do you stretch it and make it last? Great article and I thoroughly enjoy reading your articles throughout the day as I am new to investing and taking my money into my own hands.
April 22nd, 2008 at 6:55 pm
An annuity salesman is just that… a salesman. And just like those hucksters who peddle life insurance they try to sell you on fear. Fear is a great tactic for selling anything. How else do you think car salesmen still sell those giant, gas-guzzling SUV’s? Safety… or fear that if you have your family in a Honda they won’t survive the crash. They always present you the worse case scenario. Your best bet is to steer clear of them. Annuities are not for most people.
April 22nd, 2008 at 7:12 pm
What complicates this even more is the RMD. Assuming the 600k is in a pre-tax account (and if the assets are rolled into an annuity as qualified assets) then you have even more issues to consider.
Just plugging 600,000 into an RMD calculator shows that even at just a 5% rate of return will require more than 30k to be taken out as an RMD by age 73. And it just gets higher and higher from there.
So, to get an accurate comparison, you’d have to plug the numbers and rates of return into an RMD calculator since $30,000 consistently is not realistic in a qualified account. Depending on the rates of return, you may be required to withdraw 60-80k/year after getting into retirement a bit.
Of course, none of this applies if it is all in a taxable account or roth, but I highly doubt that is the case.
So, it would be interesting to see what effect the RMD has on ending account balance and annual income. I think you have more excel spreadsheeting to do JLP
April 22nd, 2008 at 7:25 pm
Jeremy,
That’s a good point. Of course, there’s nothing that says a retiree can’t pull out the RMD and invest the excess in an index fund.
This is another reason to consider the Roth IRA since it doesn’t have RMDs.
April 22nd, 2008 at 7:55 pm
Unless you are in a country where the tax laws give annuities a major edge over the altenatives, they are a lousy investment….unless you happen to be the hustler pocketing a bog fat sales commission. The only positive thing that can be said about them is that they give an assurance of mediocre returns – you avoid the risk of disasterous returns in all situations except insolvency of the provider.
Where the difference between 5% and 8% really bites is when inflation is taken into account. If inflation is running at 3%, then the real rates of return become 2% and 5% – the annuity would show a real rate of return which is less than half what a portfolio of other investments would show. An annuity would be a disasterours invetsment if inflation rises. Yes, I know that inflation linked annuities are available but are they really worth the cost?
April 22nd, 2008 at 8:32 pm
Hi, I would really love to see this redone with inflation taken into account. All these numbers posted above seem meaningless without an inflation adjustment each year. Assuming 3% inflation, the $30,000 withdrawn in year 30 has a value of only $12,402 in year 1′s dollars.
So for the fixed annual withdrawal scenarios, the fixed amount should be increasing by 3% (or whatever) each year, so that the VALUE remains fixed.
And for the fixed-percentage withdrawal scenarios, a column could be added to show that amount’s value in year 1′s dollars.
Am I making sense? This is all new to me too.
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April 23rd, 2008 at 8:02 am
One point here about annuities is you don’t have anything left at the end. The insurance company gets the remaining amount. So even if they sell you a fixed annuity, you may not have fluctuations or investment risk (although you now have the risk the insurance company will go under), but you aren’t guaranteed to leave anything to your heirs even if you die early. You can take a guaranteed payment term, but then your payout is much lower.
Annuities are sold, not bought. Annuities pay the highest commission of all the investment products on the market, which is why they are recommended so often.
April 23rd, 2008 at 9:03 am
Annuities can be decent investment vehicles, but it really takes certain circumstances.
I find it strange that this chart shows the first couple years with negative returns and then jumps to a consistent 8 % return for the rest of the annuities life – where is the correction years, meaning double digit returns.
April 23rd, 2008 at 10:25 am
MilkYourMoney said:
“I find it strange that this chart shows the first couple years with negative returns and then jumps to a consistent 8 % return for the rest of the annuities life – where is the correction years, meaning double digit returns.”
I posted the charts as they came to me from the reader except the chart with the consistent 5% withdrawal rate, which I created. You’re correct though, if this person experienced a 20% decline in one year, they would most likely experience years of double-digit returns.
April 24th, 2008 at 12:13 am
You could ask him where the insurance company gets the money from to pay the annuity. Annuities are bets you will live longer than the others buying them. If you are convinced you will, they can be a good buy if the fees aren’t too hefty. Otherwise doing it yourself may be better.
April 24th, 2008 at 8:52 am
Another thing that gets me about the charts is that they are running 30 years after retirement. Age isn’t specified, but I’ll guess it’s in the range of 60-90 or 65-95. Is it realistic to assume that seniors, as they approach such ages, will remain 100% in equities? Even if they were half and half, and CD’s only returned say 4%, that would drop the negative side on the first year to -8% while only dropping the positive side to 6%, and you’d still have about $75,400 left over after 30 years.
April 25th, 2008 at 10:21 am
Newer generation variable annuities have more features than in the past. Excersizing the annuity feature is an option, but not required. Your funds grow and you may withdraw so much of your account value without diminishing your annuity value which is stepped up every year at 6-6 1/2 % in the event you want to annuitize your account. The goal is not to annuitize unless you run out of money. At 64 years old, I sleep better knowing there is a minimum income coming in. I view these products as insurance so I don’t run out of money, but I can stay in the market to deal with inflation. Insurance is never cheap and its never a great deal unless you need it.
April 25th, 2008 at 10:27 am
Just stumbled across your blog, and, at first blush, it seems quite interesting. I would concur with the majority opinions that annuities are lame. With very little effort, I built my own self-directed annuity, using financial calculators readily-available on the web (I use moneychimp’s). I originally funded it to throw off a level $65,000/year for ten years using a series of laddered CDs averaging 5.75% APY. With a little tweaking, I extended the ladder to eleven years, taking advantage of a nice CD at KeyDirect then offered at 5.75% for ten years. If you have the time, it’s not rocket science to build your own annuity. You then have the freedom to revise it as your situation changes. Oh, by the way, when the CD ladder is used up, I fund another with my other IRA in Vanguard (stocks/bonds) which (hopefully) has kept growing while the CD ladder has been tapped. The concept is to withdraw 4%/year while maintaining an average return of at least 5%/year, a formula used by many large endowments. The kids get the remainder when my wife and I die. Why pay an insurance company (and its sale force) when you can do-it-yourself?
Yours,
Bozo
April 27th, 2008 at 12:11 pm
I dont have a problem with annuities per se, but i do think people buy them at the wrong time and in the wrong circumstances. Here’s what I mean.
Assuming you have a large yearly income. You can only contribute so much to a 401k/403b/457.. Same with a Trad or Roth IRA, SEPP’s and so on. The only reason i would get in to an annuity is after I have maxed out everything else.. and get in to the annuity only for the tax shelter.
How I would do it.
401K upto the match
ROTH IRA
back to the 401k to max
Variable Annunity.
Index Funds in Taxable Acct.
February 5th, 2009 at 9:52 pm
Just stumbled across this blog. I’m curious what you think about being invested in the market now for those at retirement? Even the most balanced portfolio’s were hammered. And the fact that you would use static returns is so misleading. You show me a market that gives a constant 8% or 10% return as you illustrated and that’s where I’ll invest. Most any study you find on taking distributions state that anything over a 4% withdrawal indexed for inflation will likely cause you to run out of money if you live long enough.
It’s amazing to me how people talk about things as if they are experts when they are so misinformed. For example, KC calls someone who sells an annuity a “huckster” like those that sell life insurance. I gladly purchase life insurance to take care of people I dearly love in the event I pass away.
Then Kirk talks about not leaving anything to your family. He says there is “nothing left at the end” and “the insurance company gets the rest”. Only if someone annuitizes the annuity. Does he not realize there are many fixed annuities out there that act much like CD’s? Of course he doesn’t. Otherwise he would have never typed what he did. CD’s are currently paying in the 2.50%-3.00% range. Many of these “CD type” annuities are paying upwards of 5% interest.
Then there are those that talk about the “big fat” commissions. Do any of you know what a company pays an agent on a 3-4 year “CD type” annuity? I’d love to hear what constitutes “big fat”.
Lastly, it would be interesting to see how Israelsen’s portfolio is performing now. The one thing that most people forget is most investors let their emotions get in the way. They see the market dropping and jump out when the market is near the bottom. Then, after the market has recovered, they decide to finally take another chance and jump back in near the top. Repeat cycle. This is a recipe for disaster.