By Howard Hook, CPA, CFP
Howard Hook is a fee-only Certified Financial Planner and CPA with the wealth management firm of EKS Associates in Princeton, NJ. He has been named to Medical Economics’ list of top financial planners for physicians for nearly a decade and is a member of the Forbes’ Finance Council and contributor to that publication.
To be as concise as possible, there are two components which contribute largely to the success of one’s retirement plans: investment return and how much money you need to withdraw from your portfolio, known as your withdrawal rate. This is not to say that there are not other key variables.. But those two are a good place to start when evaluating your retirement prospects.
Investment return and withdrawal rate are inextricably linked. If your investment return in a given year is less than your withdrawal rate, then your investments will decline in value that year. This becomes a race between your portfolio and your life expectancy, which is akin to the gag when you were a kid: heads I win, tails you lose. Dying early reduces the likelihood of you running out of money (but, of course, it also comes with the downside – you are dead). Living a long life increases your time here on earth, but puts extra strain on your portfolio and could cause you to outlive your portfolio
Obviously, in those years that your investment return exceeds your withdrawal rate your portfolio will increase.
If we break it down even further, withdrawal rate is dependent upon your living expenses and outside sources of cash flow, other than from your portfolio. The most common forms of cash flow for most people are social security and pension income (for those lucky enough to have one).
To calculate your initial withdrawal rate from your portfolio at retirement you simply add up your cash flow sources, subtract from that your expenses (including income taxes) and divide the result by your total portfolio to get the initial withdrawal rate. Spoiler alert – if you are between the ages of 65 and 70 and this calculation yields a number greater than 4%, something needs to change (e.g. return to work, spend less, or marry someone with a pension).
Investment return is a tricky one. Most investments do not go up (or down) the same amount each year. As such, there is some degree of variability to those years when investment returns will exceed the withdrawal rate and those years when it will not.
This means that choosing the investment portfolio with the greatest chance to exceed your withdrawal rate in any given year is not the best one to choose for your long-term success. Research has shown that a portfolio with all stocks in it has the greatest likelihood of one-year success as compared to an all bond or all cash portfolio. But that same portfolio of stocks is also likely to have the greatest likelihood of loss in a given year.
Portfolio performance compounds year after year, which can be both good and bad. Too much of a loss, especially early on after retiring can set you back immediately and make you scramble to recover. Too much of a gain can tempt you to spend more money than you originally planned (a phenomenon we saw the past few years prior to 2020) and throw you off track as well. It’s hard to reign in your spending especially during good times.
Choosing a mix of investments, some in the stock market, some in the bond market, and some in cash can provide diversification and help narrow the range of likely investment returns in a given year to assist you in evaluating whether the portfolio will sustain the withdrawals you expect to make from your portfolio.
The right mix of all three of these different types of investments is hard to generalize. Understanding the role each type plays in the portfolio, can help you begin to get a sense of how much to have in each.
The role of stocks in your portfolio should be to grow the portfolio long term over and above the rate of inflation.
The role of bonds in your portfolio is to lower the overall volatility of the portfolio and to provide a stream of income. The bond market can provide positive or less negative returns when the stock market declines.
Cash in the portfolio also lowers the overall volatility in the portfolio, but also plays the crucial role of providing for your cash needs especially during times of market downturns. Using the cash in your portfolio to provide for your needs gives your stock investments time to recover and grow once economic conditions improve.
As we work our way through these current economic conditions, those investors who understand the relationship between their withdrawal rate and their investments will have the greatest chance to emerge unscathed. That’s a good feeling to have.