The Most Important Number for Your Retirement Isn’t Your Account Balance
By Macy Jae Moore on May 30, 2023
Written by: Zeke Anders
Perhaps the most common question for pre-retirees is “How much money do I need to retire?”. Given the decline in pension plans, employees and business owners are now required to save throughout their career to build a nest egg to support retirement. The problem is that your account balance does not tell you how much you can spend in retirement. We can’t rely on long-term average returns either due to volatility. Ultimately, what matters more to retirement success is your withdrawal rate. We’ve referenced the “4% Rule” in previous pieces, but this piece will dive into the data behind it.
Two individuals with the same account balance and allocation could have different results based on their withdrawal rates. As an example, using a portfolio of 70% U.S. large cap equities and 30% intermediate term treasury bonds (due to data availability) and 10,000 sequences of randomized historical returns going back to 1972, the table below shows the probability of completing 30 years with any portfolio assets remaining. The withdrawal rate applies to the first year, and then that amount is adjusted for inflation each year thereafter. For example, for a portfolio of $3,000,000 the first withdrawal at a 2% withdrawal rate would be $5,000 per month or $60,000 per year. Each year thereafter, the $5,000 per month would be adjusted for inflation.
For illustrative purposes only
Source: Portfolio Vizualizer, as of 5/26/23
The pre-tax compound annual growth rate for portfolio was 9.44%, but as you can see even a 5-6% withdrawal rate was risky. This is the impact of volatility during the withdrawal stage. Taking more risk in hopes of higher returns will not necessarily improve the odds. A portfolio of 100% equities improved the probabilities for higher withdrawal rates, but actually decreased the probabilities slightly for lower withdrawal rates.
For illustrative purposes only
Source: Portfolio Visualizer, as of 5/26/23
Not taking enough risk, such as allocating only 30% to equities, was detrimental at higher withdrawal rates. The chart below compares all three scenarios.
For Illustrative purposes only
Source: Portfolio Visualizer, as of 5/26/23
One note on the results above. The original research by Bill Bengen[1] found a 100% probability of success for a 4% initial withdrawal rate, adjusted for inflation thereafter, with equity allocations of 50%-75%. Bengen used historical returns chronologically, without randomizing the sequence of returns. One benefit of his approach is that it accounts for the general upward trend of the stock market over time. The randomized returns do not include this trend and may be more conservative as a result.
These results largely hold regardless of the balance of the portfolio. Individuals with larger balances may be able to access private investments with higher yields and smoothed volatility, which could improve the odds. The use of buffer assets that are uncorrelated to financial markets can also boost the sustainable withdrawal rate[2]. It is important to note that this simulation only looks at a 30-year period. As we discussed in a previous piece, the length of your retirement could last longer or shorter than 30 years[3], and the duration of your retirement is highly impactful to the success of your plan[4]. The probabilities would be different if we used a 31-year period or a 35-year period or a 20-year period.
Real life is not as clean and neat as our case study, however. Many retirees have higher spending early in retirement, then spending declines, then spending increases again for medical costs late in retirement. Some people may be comfortable with cutting spending later if needed to support a higher spending rate early in retirement. If most of your spending is fixed, such as housing, car payments, memberships, etc. it may be difficult to cut back. If a portion of your expenses are discretionary such as travel, hobbies, or restaurants, you may be able to delay or eliminate those expenses if needed. Retirees with significant Social Security or pension income may be comfortable with a higher withdrawal rate since much of their income is guaranteed for life, and they will be ok even if their portfolio balance drops. This is the basis for the psychological and financial benefits of delaying claiming social security[1]. The point of this section is that probabilities of “success” are not the only measure of a sound and fulfilling retirement plan, but they do provide a benchmark for spending risk in retirement.
In the absence of defined benefit plans, the focus has shifted to portfolio balances to gauge retirement readiness. The fact is, there is no amount of money that will guarantee retirement success for everyone. To know how ready you are for retirement, you must consider both what your balance is, what percentage of it you plan to spend in retirement, and how flexible that spending is. Monitoring your plan throughout retirement to confirm you are on a sustainable path is crucial, especially as unexpected needs and opportunities arise.
[1] Bengen, William P. 1994. “Determining Withdrawal Rates Using Historical Data.” Journal of Financial Planning 7, 4: 171–180.
[2] https://twickenhamadvisors.com/blogs/unobstructed-thoughts/whole-life-insurance-as-a-buffer-asset
[5] https://www.thinkadvisor.com/2023/01/09/why-clients-shouldnt-claim-social-security-early-to-protect-portfolios/
Zeke Anders – Planning Specialist | zanders@twickenhamadvisors.com
Disclaimer
Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.
