Compounding, as we all know, is a very powerful tailwind that propels our retirement security forward if properly harnessed. But, sadly, compounding also provides a powerful headwind that pulls down our retirement security when we consider "fees," "inflation" and "taxes" (FIT). Most of the time, when we do quick calculations about how much we need for retirement, we omit fees, inflation and taxes that must be accounted for.
Fees, Inflation and Taxes Suck
Consider a simple example: Assume that you need to withdraw $24000 a year from your retirement accounts (401K, IRA, etc.) to cover your retirement expenses. Assume that you commence retirement in 2030 (for example). Clearly, each year costs rise each year so that by 2030, $24000 in 2018 dollars is actually worth less. Or, put differently, in 2030 we need to withdraw more money from our account so that it is actually worth $24000 in constant 2018 dollars. Assuming inflation is 2% each year, this works out to (approx.) $30437 (in 2030). Now over 35 years of retirement (ending in 2064), this number further grows to approx. $59678.
When you add in taxes that must be paid on amounts withdrawn, the numbers get even larger. Assuming a 10% tax rate, fully loaded withdrawal that includes inflation and taxes grows from $33819 in 2030 to $66309 in 2064.
If you think you need to withdraw $24000 each year for your retirement, this works out to $840000 over 35 years - no inflation/taxes. Add in inflation, and over 35 years this total is $1,521,722. Add in taxes and this number is $1,690,802 - more than 2x!
So never never never ignore these when you do your long-term calculations to gauge your retirement health. I call these three the "bad cholesterol" of financial health - they silently deposit plaque in your financial arteries eating away at your returns.
Averages (and, medians) Mislead. Test your plans against historical return SEQUENCES.
First, an apparent paradox. Two people Bill and John are financial clones (identical portfolios, identical annuities, interest gained, tax rate, withdrawal amounts, etc.). They both plan for 35 years of retirement and think they are doing well. Bill reaches retirement age of 65 and goes through retirement - with no money problems. John too reaches retirement at 65 but part way through retirement runs out of money! How is this possible? Answer: When Bill retires he is lucky - the early years of his retirement have positive returns in the market. The amounts he gains from his investments offset his withdrawals so his balance grows and compounds. When withdrawals grow larger in later years and market declines come, his balances have grown sufficiently to cover these years. John is not so lucky - when he retires there are a few early years of market declines. His assets + withdrawals decline. Later as the markets recover, the assets start growing but by then his withdrawal amounts have risen (because of inflation) causing him to never fully recover. He runs out of money later in retirement, sadly!
I have seen numerous folks (both in our classes/webinars) as well here on the sub make statements to the effect "I am assuming a conservative x% return on my portfolio...." implying that because x is conservative they should be OK. This works well (to a first approximation) for initial planning but not for gauging whether you will be solvent through your retirement. Your solvency during retirement is based on two opposing forces: 1) the balance decreases as we withdraw amounts to meet our retirement needs. These amounts increase each year due to inflation/taxes (as we discussed earlier). 2) the balance increases or decreases as our assets rise/fall with the market depending on our asset allocation. If the increases generated by the latter outweigh the reductions of the former, we will be OK. But, if the balances decline faster than our assets rise, we may run out of money in retirement.
Let's illustrate this with an example: Consider two sequences of annual % returns (of S&P 500) shown below. Return 1 is the annual return of S&P 500 index (including dividends) for the 35 year period from 1982 to 2016 (inclusive).
| Index | Return 1 % | Return 2 % |
|---|---|---|
| 1 | 14.07 | 19.31 |
| 2 | 16.59 | -10.05 |
| 3 | 1.75 | -12.92 |
| 4 | 25.37 | -23.02 |
| 5 | 14.07 | 26.05 |
| 6 | 2.35 | 9.04 |
| 7 | 12.37 | 3.18 |
| 8 | 26.81 | 13.59 |
| 9 | -6.18 | 3.67 |
| 10 | 25.54 | -37.73 |
| 11 | 4.25 | 22.10 |
| 12 | 6.87 | 12.56 |
| 13 | -1.36 | 0.29 |
| 14 | 33.32 | 13.51 |
| 15 | 19.92 | 29.31 |
| 16 | 30.48 | 11.34 |
| 17 | 26.32 | -0.53 |
| 18 | 19.31 | 9.45 |
| 19 | -10.05 | 14.07 |
| 20 | -12.92 | 16.59 |
| 21 | -23.02 | 1.75 |
| 22 | 26.05 | 25.37 |
| 23 | 9.04 | 14.07 |
| 24 | 3.18 | 2.35 |
| 25 | 13.59 | 12.37 |
| 26 | 3.67 | 26.81 |
| 27 | -37.73 | -6.18 |
| 28 | 22.10 | 25.54 |
| 29 | 12.56 | 4.25 |
| 30 | 0.29 | 6.87 |
| 31 | 13.51 | -1.36 |
| 32 | 29.31 | 33.32 |
| 33 | 11.34 | 19.92 |
| 34 | -0.53 | 30.48 |
| 35 | 9.45 | 26.32 |
| Median | 12.37 | 12.37 |
| Average | 9.76 | 9.76 |
Return 2 is a simple permutation of Return 1. The only distinguishing characteristic of Return 2 is that the three negative returns that appear toward the middle of the sequence in Return 1 now appear towards the beginning. Both have identical averages (9.76%) and medians (12.37%) - both of which are actually stunning annualized returns.
If you begin retirement with $750,000 in your retirement accounts with 40% allocated in S&P index, withdrawing $24K each year (duly adjusted for inflation and taxes) as in the previous section, you will see the following surprising conclusions (in the next section we will provide a link to a spreadsheet where you will be able to play with this example):
- Using the Return 1 sequence of annual returns (starting with 14.07% in the first year and so on), you are able to nicely complete 35 years of retirement.
- But move the negative returns to the beginning as in Return 2 - and now you can only complete 22 years of retirement. Darn! Going broke late in retirement is no fun at all!
- Instead of using the sequence of returns, if you used the median of 12.37% annual return, then again you handily complete the 35 years of retirement.
So crucial lesson - when evaluating whether your withdrawal plans during retirement work stress test different return sequences for your portfolio just to make sure that you are covered. We created a spreadsheet for this purpose that can help you - more on this in the next section. Another concrete suggestion: Plan for a range of retirement start years so that if you approach retirement age as markets are declining, you can stay working for a couple of additional years to avoid the blight of this early market declines screwing up the rest of your retirement.
A Spreadsheet to help you
We created a spreadsheet that allows you input a) your desired retirement year b) the balance in your retirement accounts that you will commence retirement with c) tax rates, d) asset allocation and associated returns, e) inflation rates and f) fees. (Caveat - we built this calculator to show case the impact of inflation, taxes and fees, and also the importance of planning for a series of market declines early on in retirement. We are using the S&P 500 index as the indicator of market performance. If you choose a different index - Dow, Russell 2000 or other - your data will vary. But the broad conclusions will still be valid. Also, this calculator is not intended to replace/subsume other retirement calculators out there.)
First, if you have Excel, feel free to download the spreadsheet and work with it. It has no viruses/malware :-) If you don't have Excel, here's what you can do.
1) Sign in to your Google account (if you don't have one, please create one).
2) Click the above link and open it in Google Sheets.
3) You should now be able to edit it to suit your needs. If, for some reason, edits are not allowed, click on File->Make a copy - and make a copy for yourself which you can edit to heart's content.
A quick run through this spreadsheet:
First: The "Start" worksheet is the place where you make changes to model your particular situation - primarily in cells B1 through B12. Read the comments in each of the cells A1 - A12 so you can get a sense of what we are modeling, etc. As you make changes, watch the summary in the section that says "Summary" - your goal is to reach 35 in this cell - which means that you have been able to fully fund your retirement. If you want to model longer/shorter retirements, you can make the changes pretty easily but this will require you to know Excel.
Second: Row 10 contains your asset allocation - how much of your assets at/during retirement will be in stocks/bonds/cash & equivalents. Be conservative.
Third: Cell B11 is crucial - it controls how stock returns are computed. We assume S&P500 index (including dividends). The worksheet titled "Data" contains S&P index values and annual returns from 1927 - 2017. Inflation data is also included for these years - but is currently unused in the model. If you want to specify your own annualized return, choose "Constant" and specify the actual return value in Cell B12. Otherwise, you can choose between "Best," "Middle" and "Worst". Best, middle and worst of what? What we have done is to take the entire S&P 500 index returns from 1928 to 2017 and generate 56 return sequences of 35 years (because we are modeling 35 years of retirement). One sequence starts in 1928 and ends at 1952, the next at 1929 and ends at 1953, and so on until we get to the last sequence from 1983 to 2017. We take these 56 sequences and sort them by median return, and break ties with total return over the 35 year period. If you choose "Best" then the return sequence that will be used to model your 35 years of retirement will be taken from the years 1979 to 2013 - because this sequence of 35 annual returns performed the best overall. If you choose "Worst" you will be modeling the Great Depression (the sequence starts in 1928 and ends in 1962).
You can see all the 56 periods in the worksheet "SP500Analysis". A few noteworthy points:
- Every period of 35 years had atleast 7 negative years - approx. 20%. This means that in your retirement you can count on 20% or more of the years to be negative. The maximum number of declines was 14 (which is 40%).
- There is no period that has more than 5 consecutive declines, though 4 consecutive declines occurred once during the Great Depression (1929 - 1932). Three consecutive declines have occurred 3 times over the past 90 years.
Fourth: There are additional worksheets that help you estimate more precisely how much you should plan for withdrawal during retirement - you can fill out the "RetirementWithdrawalWorksheet" - the core idea is taken from Tony Robbins' Master the Money Game. Likewise, the worksheet "KnowYourFeesWorksheet" allows you to systematically estimate the fees you pay for the various retirement investments, etc. As we know fees are pernicious - so estimate this carefully because they eat into your returns.
Fifth: The worksheet "SequenceMatters" illustrates the fact that merely changing up the sequence of returns moves you from a successful retirement to one in which you run out of money. Make sure that you play with this to really understand this!
Summary
- Don't ignore fees, inflation and taxes.
- Aggregate returns (like averages/medians) may sometimes lead you astray - understand the return sequences - and make sure that your retirement assumptions are valid.
If you have any questions, drop me a PM and I can try to help. If you discover bugs in the spreadsheet, please correct it and send back to me - I will then update it so that everyone can benefit.
Good luck!
Submitted April 18, 2018 at 08:38AM by arnexa https://ift.tt/2HGT5Hr
