Will your money last as long as you do? How about your spouse? Many retirees plan for too short a time horizon and misjudge how much money they can safely withdraw during retirement.
Life expectancies have been steadily increasing. According to the National Institutes of Health (NIH), average life expectancy has risen about nine years since 1952. Today, the average life expectancy for a 65-year-old is 84 years, as shown in the following table.1 And that's just the average—half could live even longer.
Source: Internal Revenue Service
Given rapid advances in modern medicine and health care, you simply must plan for a longer investment time horizon than your parents or grandparents did. And don't forget about your spouse's time horizon! Longer life expectancies present a challenge to today's investors not faced by previous generations.
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Investors often have unrealistic expectations about how much money they will be able to safely withdraw annually from their portfolios.
A common but incorrect assumption is that since equities have historically returned approximately an annualized 10% over long time periods,2 then it is safe to withdraw 10% per year without ever drawing down the principal.
Nothing could be further from the truth!
While equities have historically returned approximately 10% annualized,2 because of inflation (approximately 3% annualized)3 the real return on investment is approximately 7% annualized.
The following table demonstrates the potential impact of taking annual withdrawals equal to 10% of the beginning portfolio value from a $1,000,000 portfolio over 30 years (adjusting for inflation). In this example, the probability the assets survive the entire period is low, as is the probability of growing the assets--no matter the asset allocation.
This table is based on a Monte Carlo Bootstrap portfolio model. Bootstrap re-sampling is a type of Monte Carol simulation, a technique which allows for random sampling of historical stock, bond and cash returns while incorporating historical inflation,. The simulation takes 2,500 iterations of 30-year historical periods and uses them to calculate averages. This statistical method is non-linear and allows for the assignment of probabilities to various outcomes.
Another important factor: Markets are volatile, and taking a 10% withdrawal in a year when the market declines could substantially decrease the probability of meeting your financial objectives. For example, if your portfolio is down 20% and you take a 10% distribution the same year, you will need about a 39% gain the following year just to get back to even!
Inflation will also affect the size of the withdrawals over time. Due to the compounding effects of inflation, a person who needs $50,000 in 2012 to cover annual living expenses would need approximately $90,000 in 2032 and $121,000 in 2042 to maintain the same purchasing power.3
To learn additional factors that could affect retirement investing, click here.
1 The US Total Population Life Table 2007 (revised as of 06/25/2010) National Vital Statistics Reports, Volume 58, Number 21. Life expectancy rounded to nearest year.
2 S&P 500 Total Return 12/31/1925-12/31/2012 = 9.72%,
Source: Global Financial Data, Inc., 1/18/13. The S&P 500 Total Return Index is based upon GFD calculations of total returns before 1973. These are estimates by GFD to calculate the values of the S&P Composite before 1971 and are not official values. GFD used data from the Cowles Commission and from S&P itself to calculate total returns for the S&P Composite Price Index and dividend yields through 1970, officially monthly numbers are from 1971 to 1987 and official data from 1988 on.
3 US Bureau of Labor Statistics Consumer Price Index 12/31/1925-12/31/2011 = 2.98% inflation rate Source: Global Financial Data, Inc., 1/18/12
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