There has been much discussion in the financial press about how to fund income for retirement. Much of this discussion deals with how to safely take withdrawals from an investment account in a manner that will make the funds last at least as long as the individual’s life expectancy.
Many of these models use modern portfolio theory to allocate assets among different classes and then run these various asset classes through “Monte Carlo” scenarios to figure out the odds of the assets lasting as long as the client. The results of these studies usually are phrased in sentences like: You have a XX% chance of your money lasting until age YY as long as you only withdraw Z% of your portfolio per year. After working with several individuals who had based their retirement planning on this logic and then retired in 1999 and 2000, I thought that there had to be a better way.
There are three basic flaws in this sort of planning that need to be addressed:
1. A 30% drop in portfolio value early in retirement would devastate the income safely available. While not common, we are well aware this has happened more than once.
2. It’s impossible to die exactly at your life expectancy. If you plan at age 60 for 20 years of additional life, when you are at age 80 (when 60-year-old males are supposed to die), you have a life expectancy of about eight more years. At 88 you have almost five more years to live. Thus the life expectancy model is a moving target that will never be accurate. Life expectancy is based on the law of large numbers and can’t be brought down to the individual level.
3. Should the money not last as long as the client, what will the client do for income? Social Security will not be adequate.
Annuities have been shunned because of their lack of liquidity, their inability to adjust for inflation and the lack of an inheritance for the heirs. While some of these objections can be overcome with newer products, the loss of control over the money keeps annuities from being the perfect stand-alone answer.
A combination of these solutions can be made into the ideal solution for retirees. In the effort to compare and contrast investments with insurance, I have combined stocks, bonds, investment real estate, mutual funds, CDs and any other investments into a “Nest Egg” earning a stated percentage return. Using Excel 2003, it is possible to look at some hypothetical scenarios for a male retiring at age 65 with a $1 million portfolio balance.