Looking for the Perfect Retirement Formula?


Conventional wisdom says that you can safely withdraw 5% of your Net Worth each year following ‘retirement’ (hence, the Rule of 20), but conventional wisdom is aimed at people who conventionally retire … which, I trust, is none of us 😉

However, there are essentially two conventional ways of deciding your retirement ‘income’:

There’s the percentage of portfolio method (where you always withdraw the same % of your portfolio each year) and the dollar adjusted method (where you always withdraw the same fixed $ amount, only adjusted each year for inflation).

Colleen Jaconetti, from Vanguard Investment Counseling & Research says:

The percentage-of-portfolio method can give your money a greater chance of lasting throughout your lifetime, while dollar-adjusted gives you a more predictable, inflation-adjusted withdrawal amount each year. If you’re more concerned about someday running out of money, the percentage method may be appropriate, but you’ll need to have some flexibility in your spending.

The percentage of portfolio method tends to last longer, making it more suitable for those of us who intend to retire young … and isn’t that all of us?! Colleen agrees:

If you’re retiring early, such as in your 50s, you may want to start out withdrawing closer to 4% to help reduce the risk of a long-term shortfall.

But, the problem isn’t with the method – in fact, in the first year of your retirement, they produce the same result (it’s only in subsequent years that they vary according to your then-current Net Worth OR according to inflation, depending upon which method that you choose) – it’s with the factor that you choose.

You see, 5% (or even 4%) may be too much!

These ‘common wisdom’ percentages assume average rates of return, but the market doesn’t operate in a line that simply tracks the averages … it moves around the average return randomly

… and, if it randomly moves the wrong way too early and for too long (pity those who are recently retired) you could easily run out of money in years, not decades!

So, you could instead plug your numbers into a Monte Carlo Simulation (this is a really good one) which tend to produce much more conservative withdrawal rates – more like 2.5% (hence my Rule of 40).

Or, you can go the other way and set up a Bond Laddering strategy that Paul Grangaard claims can support a ‘safe withdrawal rate’ as high as 6.6%.

Do you see our dilemma? A doubling or tripling of life-style (or a similar scale reduction, depending on whether your glass is half full or half empty) depending upon whom you believe.

This is the dilemma that you face when your retirement assets are held in bonds, Index Funds, cash or CD’s … which is why I am trying (actually, failing miserably right now) to live a $250,000 lifestyle on an income and asset-base that actually supports way more than that (I think: I’ll have to wait for the post-meltdown; post-house-purchase; post house-renovation; post-move countries fallout to clear sometime during 2009 to be REALLY sure I’m still living within my means … I think – more likely hope – I am).

So, when I find the Perfect Retirement Formula, I’ll be sure to let you know … Lord knows, if it exists, I need to find it 😉

In the meantime, I have a third method – one that makes the concept of Safe Withdrawal rates virtually irrelevant:

You invest your money in income-producing assets …

… such as, dividend-producing stocks or income-producing real-estate.

You buy the asset with little or no borrowings (which is entirely different to the Making Money 201 strategies that I recommend, but we are now in Making Money 301 – ‘post-retirement’ wealth protection mode – so things change dramatically) and gain the following two huge advantages:

1. You can live off the entire after-tax rent/dividend – with a buffer for holding costs (in the case of real-estate, this could be things like vacancies, taxes, and repairs and maintenance), if required – which is pretty much automatically inflation-adjusted, and

2. Your capital (hence estate) or Net Worth also increases pretty much at least with inflation, as long as you choose your investment/s reasonably well!

No worries about outlasting your income … and, you get to leave your heirs (and/or your favorite charity/s) the bulk of your ‘fortune’ 🙂

PS What does the image of a man running on the beach have to do with a ‘safe retirement’? I have no idea … I just googled images with the keywords ‘safe’ and ‘retirement’ and pictures of beaches and horses (lots of horses!) came up … go figure …