November 2012: Retirement with Love—How Investment Returns Affect Your Retirement

By Howard Pressman, CFP®
Certified Financial Planner™
Egan, Berger & Weiner

Picture this: James Bond, aided by a drop-dead-gorgeous nuclear physicist with a name that doesn’t even vaguely hide its sexual innuendo, is trying to disarm a bomb hidden under the Queen’s throne.

The bomb has a digital display, and James must enter the disarming code exactly as he read it when it was left unattended on the villain’s desk during the “I’m Gonna Blow-Up the World” masquerade ball. If he gets the sequence wrong, he’s going to blow the Queen (and himself) to kingdom come.

If he gets it right, he hops a little dingy and spends six blissful days on the ocean with Ms. Nuclear Physicist. Drawing down your retirement savings is very similar—if the sequence doesn’t go just right, it’s possible that the whole thing could blow up in your face.

Many Baby Boomers nearing retirement think that amassing their retirement savings was the hard part.

Well, I hate to be the bearer of bad news, but that was easy by comparison. Long timeframes and the constant influx of new money can mask many problems. So what is the tough part? Turning this pile of money into a reliable, inflation-adjusted stream of income with a low probability of turning to dust before you do.

To illustrate my point, consider the following hypothetical sequence of annual returns achieved during 25 years of retirement: 29%, 18%, 25%, -6%, 15%, 8%, 27%, -2%,15%, 19%, 33%, 11%, -10%, 5%, 17%, 21%, -3%, 3%, 11%, 4%, 10%, 22%, -14%, -21%, -12%.

If you average these out, it comes to a 9 percent average annual return. Not bad by any standard. For the sake of this example, we’ll assume that you start out with a portfolio value of a million dollars, and you desire to withdraw 5 percent of the value, adjusted annually for inflation, which we’ll assume to be 3 percent. Under this scenario, your money would have successfully lasted through your 25-year retirement.

In fact you would still have about $8.5 million left over, just in case you lived longer. How’s that for a happy retirement?

Now, let’s reverse the above sequence of returns.

The exact same numbers, just backwards. The average annual return is the same 9%, which is still not bad. We’ll take out the same 5 percent each year, still adjusted for 3 percent inflation. Any guesses as to what the result will be?

If you think it’s the same, or even close, you should practice living on Social Security. If you guessed that you’re living in a refrigerator box, then you get a gold star. The truth is that you are flat broke in year 17! If you had retired at 65, you would be out of money at age 82.

How did this happen?

  • The reason is that in scenario one, you started off with three good years, 29%, 18% and 25% and ended with three bad years. You were already up a cumulative 82% before you experienced your first negative year.
  • In scenario number two, you started off with three bad years in a row. By the time you had a good year your $1 million portfolio was down to $466,567.
  • To make things worse, you were withdrawing your 5 percent each year from a shrinking pot of money.

We obviously can’t control the returns of the markets, so how do we help protect ourselves?

There are a few ways.

1. First, we need to start with realistic expectations as to how much income we think the portfolio can comfortably throw off.

2. Second, we want to reduce the likelihood that we’ll have to withdraw from the investments during a bad year. Some may choose to use an immediate annuity, which can provide an income stream that is guaranteed by the issuing insurance company. Others may choose to utilize separate pools of money in different types of investments, such as a few years’ worth of expenses in bonds with staggered maturities.

3. Third, we should put in place rules that act as guardrails to help keep us from going astray. These rules may determine where the next year’s withdrawals will come from, or in what circumstances we take less or even more money.

Most likely we’ll need to use a combination of all the above.

During your working years, the goal is to grow your money. Once you’re in, or close to retirement, the goal is to provide income. Your goal has changed, so your investment strategy needs to change as well.

I’m not talking about a product here, I’m talking about a comprehensive process that takes your individual situation into account and creates a customized strategy built around you. This is more than what we can expect from a computer program; to work best, it requires a close collaboration between you and an experienced advisor.

With 2008 still looming fresh in our minds, and life expectancies getting longer each year, those of you contemplating retirement in the near future should seriously consider the impact of negative returns and how they may affect your ability to realize your vision of retirement.

The choice is yours. Do you want to blow the Queen’s bum off, or would you prefer to sail into retirement with Dr. Ivana Feihlguud?

About Howard Pressman

Howard Pressman holds a Certificate in Financial Planning from Georgetown University. As a CERTIFIED FINANCIAL PLANNER™ practitioner, with 14 years of experience, he helps individuals, families, those in retirement, and those nearing retirement make sense of the seemingly complex world of personal finance.

Pressman has written numerous articles on financial planning for local newspapers, and for the CFP Board’s newsletter. He volunteers with several nonprofit organizations where he teaches financial planning basics to families who may not otherwise have access to a financial planner. He is a member of the Financial Planning Association and the Investment Management Consultants Association.

A lifelong Washingtonian, Pressman lives on Capitol Hill with his wife, Erica, and their daughter, Tali.

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