Friday Finance - the arc of descent

A visualization of what can happen to retirement funds over time

Source. Don’t be alarmed, she’s fine

When planning retirement, it’s helpful to consider some visual representations of potential outcomes to get your head straight about what to expect.

Consider the following graph of how long retirement savings may last.

Assumptions – $500k, initial monthly withdrawals of $2,000 per month increasing by 3% per year for inflation (fingers crossed that will be enough), 6% annual returns, disregarding tax and social security:

If these assumptions turned out to be correct, the chart shows how well the retirement fund would last over 30 years. There are many unrealistic factors here, chief among them consistent 6% returns, but overall it give a good model of one of the common outcomes of retirement planning.

Look at the shape. The funds actually increase in value slightly for quite a long time, then decline over the last decade. This is because the retiree is cutting into the principal, i.e. the originally invested amount. He is not only living on interest/dividends/other returns.

It’s not necessarily a problem. If his retirement lasts 30 years, he still leaves behind $150k to the Carousel Widows Benevolent Fund.

It’s only an issue if he lives much longer than 30 years. What a thing to worry about.

A lot of self-funded retirees’ accounts end up looking more like this. Assumptions – exactly as above but with 7% annual returns:

This is what happens to those retirees too terrified to cut into the originally invested amount in case it runs out, or simply don’t manage to spend much money after a certain age.

It seems reassuring but consider: she’s got about $600k left by the time she shuffles off the mortal coil. Unless it was her intention to leave someone a large inheritance, that’s a lot of stored value from her or her husband’s hard labour to leave unused.

Just so you can see, this is what annual 8% returns look like:

Sometimes it happens like that. If it happens to you, remember that you need to increase spending, sort out estate planning or figure out something else to do with these unexpected riches or they may go to waste.

It’s beside the point but let me say, I’m not a big fan of death inheritances. If you die at 90 then your kids are probably around 60. Surely it’s better to see this situation coming and help them earlier, when they’re starting their own families. None of this applies to me; I’m thinking of others.

Anyway, moving on. We must look at the example you’ve been dreading. Here it is, assuming 5% annual returns and everything else is the same:

Whoops. In this case, the money ran out before 30 years did.

Keep in mind that in real life, the retiree can see how things are going after 15 years and reduce withdrawals. Also keep in mind that the ’30 year retirement’ figure is pulled from an arse – some retirements are longer, most are shorter.

A further factor is that returns are much, much more volatile than this. As explained in a previous post, retirees will figure out over the first decade whether or not their strategy is working and whether they need to change track. They needn’t get right to the end and suddenly realize they’ve run out.

Also, the lesson here is not, ‘you need to get at least 6% returns’. That’s how it turned out in this example but with other assumptions and inputs it might come out differently. All we can do is estimate, which is what we’ve been doing here.

What to do?

There’s no perfect solution, only options, each with its own pros and cons.

You could avoid cutting into the principal by limiting withdrawals, by dividend investing or similar. This would suit a person wanting to leave a large inheritance or bequest, or someone who wants to be buried with his treasure like a pharaoh.

You could purchase an annuity, which pays out until death. My problem with these is that many of them are a terrible deal. If governments are going to let social security/age pensions erode due to demographics and lack of funding, at least they could establish some sort of guaranteed, self-funded annuities that aren’t a complete rip-off. That’s a big topic I might look at another day.

Anyway, the next option is to aim for the first graph in this article, accept the risk that it might turn into the last graph, and be prepared to change direction as required. Realistically this would work fine for most people @ 4% withdrawal rate in the first year, but of course one would worry about the small chance that it might not work due to higher than expected inflation or lower than expected returns.

Any other ideas from the peanut gallery?

Conclusion

Well gentlemen, make your choice: leave a stash of cash behind, get stooged by an annuity or try to spend most of the money before you die and risk running out.

Enjoy your weekend.