Hi Guys,
A few days ago Dex titled a post “Is $1 Million Enough to Cover the Average American's Expenses in Retirement?”. It attracted a considerable MFO readership and many heated responses.
This big 1M dollar retirement question collected an impressive 79 total exchanges. That’s the good news; the bad news is that those responses came from only 13 independent sources plus Dex, who actively participated in the discussions.
However, regardless of all this activity, only one responder, Junkster, immediately addressed the 1M dollar question. Junkster and I did comment specifically on amounts below the 1M dollar threshold that reflected Dex’s specific budget circumstances.
The other responders mostly commented on other critical retirement issues like health costs. That’s fair given the complex multi-dimensional nature of the retirement decision.
For the most part, Dex rejected my analyses, which were grounded in Monte Carlo simulations, because they didn’t capture the nuances of his multiple wealth buckets and cash flow maneuvering flexibilities. That’s fair enough.
So I recommended that Dex do his own simulations using the highly regarded Flexible Retirement Planner tool. But not everyone trusts Monte Carlo modeling. That too is fair enough.
My eureka moment came this morning. Why not default to the simplified results of the Trinity study, which has formed a point of departure for retirement planning since 1998.
What is the Trinity study? It is a research study completed by three Trinity University professors: Philip Cooley, Carl Hubbard and Daniel Walz. The study used market data from 1926 to 1995. It defined a "success rate” as the percentage of time a retiree could withdraw a given rate without bankrupting his retirement wealth. Here is the Link to that study:
http://www.aaii.com/journal/article/retirement-savings-choosing-a-withdrawal-rate-that-is-sustainableA 4% withdrawal rate, with an optimal asset mix of 75% equities and 25% corporate bonds, generated a 98% success rate for a 30-year retirement period. At a 3% withdrawal rate, that same mix had a 100% success rate.
The Trinity study produced the heuristic 4% rule of thumb advocated for retirement planning purposes. Note that it is only a point of departure. Adjustments should be made that reflect personal preferences and current circumstances, especially the present low fixed income returns environment.
I completely overlooked this useful rule of thumb and the Trinity study that produced it in my earlier postings on this topic. Sorry for this obvious omission. I hope Dex finds this useful as he wrestles with his retirement planning. Much online literature is available on adjustments that should be made to refine the 4% basic rule.
So, in its most simplified form, when planning a retirement from the expenditure side of the equation, multiply your expected annual costs by 25 to estimate your target portfolio’s needed starting value. Dex has done a superior job from this direction.
From the allowable spending side of the equation, multiply your portfolio’s value by 0.04 to determine your survival spending allowance. Remember, the 4% rule assumes a rather aggressive portfolio equity/bond mix.
By way of closure, I did a Monte Carlo simulation for a postulated 1M dollar portfolio with Dex’s current drawdown projections over a 30-year timeframe. The analyses suggests a very high survival likelihood (like 100 %) for the one million dollar portfolio using Dex’s estimated annual portfolio return (7%).
A million bucks goes a long way with a Spartan spending budget. Given Dex’s annual budget, the answer to Dex’s original question is an easy “yes”. However, I’m not sure that Dex’s budget is representative of an “average American”.
My purpose in this post is to separate the wheat from the chaff. I hope I succeeded.
Best Regards.
Comments
Would still be awfully nervewracking, I think, if your budget from investments called for around $40k annually and your retirement party was around Labor Day 2008. Or maybe worse, New Year's Day of the new millennium.
Regardless of the method used to attempt prediction of long-term financial results, a major component of this type of exercise necessarily relies heavily on an analysis of past performance, projected forward with an attempt to consider as many potential variations as possible.
And yet, we are now in the midst of a well-established major departure from past performance, in a magic world of bonds that pay virtually nothing, and equities that are supported, temporarily at least, by the Fed equivalent of the Hindenburg. (Note to MJG: I feel no need to supply lengthy references for this postulation- much of the current ongoing discussion here at MFO acknowledges this to be the case.)
I think that it's fair to ask if any current methodology is capable of incorporating these conditions into their predictions?
Hand to mouth - I have limited resources - I have to figure out how to live within what I have (includes a job).
Hand to mouth plus - I can cover my basics with a little for simple pleasures.
Comfortable - I can live the way I want - not going crazy
1% - I can spend whatever I wish.
In my budget I noted that I own my own home. In the budget I provided a person who rents could add in money for an apartment ($18,000/year?) or a mortgage. That is what is beneficial in breaking down the spending the way I did.
So, take the basic living of 19K (minus 3K HOA/ins) and add 18K = 37K (this would be the Hand to mouth plus budget)
No SS & No pension
37,000
4% Rule
925,000 Investments
With SS
37,000
(15,000.00)
22,000
4% Rule
550,000 Investments
From the recent posts about net worth by age - many people will be living the Hand to Mouth Budget
Basic Living
House
2,117 RE Tax
2,556 HOA
489 Electric
928 Insurance
300 Misc Purchases
133 Mail Box
6,522 Subtotal House
Car 327.39
138 AAA
744 Routine Mtc.
1,164 Insurance
82 Registration
1,800 Gas
3,929 Subtotal Car
Personal Expenses
327 Income Taxes
1,200 Cash
360 Medical
340 Cell Phone
3,300 Food
600 Wine
59 Misc
396 Internet Access
300 Dining Out/Entertainment
4,029 Health Ins.
300 Clothes
- Driving Lic
-
11,211 Subtotal Personal Expenses
21,661 Total Basic Living
Incremental Living - 1
91 Travel Trailer Reg
492 Storage
Good Sam
583
Incremental Living - 2
6,256 Travel/Education/Etc
Misc Hobbies
6,256
6,839 Total Discretionary
28,500 Total Basic + Incremental
Current data, rules and regs and the calculation indicate near a minimum withdrawal rate of 3.65% in the first year from such investments, with slight increases thereafter.
Wondering about this, too; with the MC machines.
Also, LTC (long term care) health insurance policies have been noted here before, too. But from several years ago, many providers of these plans have withdrawn from the marketplace and existing plans were adjusted for those already holdings the plans and technically (IMO) breaking the contracts and/or making them so costly as to be prohibitive to retain or purchase. LTC plans which were generally offered via employer group plans are pretty much dust, from my understanding of this situation.
Take care,
Catch
Thank you for your perceptive comment. It is spot on-target. The ordering of investment outcomes is critical to the success or failure of a retirement portfolio.
An early retirement hugely negative market outcome can ruin initial survival estimates. Recovery might not even be possible. Like in any conditional probability analysis, a sudden surprise can significantly impact the originally projected survival odds in the downward direction. A recalculation is necessary with the added input.
That’s certainly one reason why a retiree must make an effort to preserve flexibility. Perhaps a reserve war-chest is the answer. Drawdown withdrawal adjustments are another candidate answer.
Many Monte Carlo codes now provide for a flexible drawdown policy input that adjusts for negative surprises. For example, after a negative year, no inflation incremental increase in withdrawal amount is permitted within the code simulation. If a second straight downward year occurs within the simulation, a reduction in withdrawal rate is automatically introduced to enhance portfolio survival chances. This is neat stuff. Of course, the retiree must be dedicated to execute this plan.
One advantage of Monte Carlo analysis is that by running a thousand or more random cases these bastard surprises are somewhat taken into account. I say somewhat because the codes that I’m familiar with underestimate their impact.
The main culprit is the Gaussian distribution normally used in these excellent tools. The historical data clearly shows that the Normal curve underestimates both the probability and the magnitude of outlier events, in both the negative and positive directions. Fortunately, these events tend to cancel one another out, but the imprecise modeling at the extremes does corrupt the survival odds a little.
I recognized that deficiency when I was doing my own Monte Carlo code. I corrected for it by using a patched set of distributions: the regular Gaussian curve for smaller standard deviations, and downward sloping curves that reflected the measured data at larger values of standard deviation. Survival rate projections changed, but not in a meaningful way that influenced the retirement decision itself.
Thanks again for your pertinent observation. It needed to be discussed.
Best Wishes.
The inputs to many accessible Monte Carlo codes are sufficiently flexible to allow a user to reflect the current market conditions and/or the user’s special market projections. These are typically input in the form of estimated average returns and their estimated standard deviations.
In running these Monte Carlo simulations, it is generally “good practice” to test the sensitivity of survival outcomes to variations in these inputs. A feeling for the robustness of the portfolio, and the drawdown schedule options, can be easily explored in this manner. A parametric study can be completed in minutes.
One issue with the original Trinity study is that it used past historical data. One shortfall of that study is that when applied to the present market conditions, it is likely to overestimate survival percentages. Inputting a more sensible set of statistics for today’s environment should produce more realistic and trustworthy outcomes.
Thank you for your question.
By the way, Catch22 and you wondered if the portfolio holdings could be segregated into taxable, IRA, Roth IRA, or equivalent buckets. Some codes “yes” but others "no”. All codes are not equal. I recall that the Flexible Retirement Planner, that both Davodrmoran and I recommended, permits that sorting. It's a pretty flexible tool.
Again, thanks for all your interest.
Best Wishes.
http://www.flexibleretirementplanner.com/wp/
I do not recall that you can spec bastard surprises for the first years, but I would be a little surprised if these guys underestimated their impact.
Certainly people who retired at the cusp of the millennium have written about their experiences, some of them anyway, online. The recovery of say VBINX since then is only a bit better than its recovery since fall of 08. Not ragging on the fund, which hits ~5%-7% annual avg depending. I never input 7% in any of these calcs, certainly not for here on out. Will be grateful for 5%.
These (for me) notions assume divs etc reinvested, none of this living off div stream and leaving principal alone.
In my old ss version, there was an input that allowed specification of both the percentage decrease and the year, to allow for modelling of a market disaster of varying magnitudes, and at different times. As I mention in the other thread, 2008 came real close to my "worst case" inputs. Fortunately, all of my other inputs were so overly-conservative that we rode out 2008 with minimal damage and no need to reduce spending.
I wish to hell that something like these tools had been available then!
Thanks for the link- OJ
Yeah, web tools are amazing these days, just amazing, in so many respects. You done good, but I am just starting out retirement, and find these good for anxiety modulation if one is prone. BoA, Fido, AARP, all have good ones, simpler, and everyone employs MC now. This one is just more complex.
Do not think of Monte Carlo simulations as some eloquent higher mathematics. It is not, I repeat NOT, sophisticated higher mathematics.
The calculation sequences within a Monte Carlo code are standard Spreadsheet arithmetic. There are only two basic differences. First, a very short random number generator and selection subroutine are an integral part of the Monte Carlo program. Second, the machine program is asked and is sufficiently fast that thousands of repetitive computations are made at lightning speed. That’s it; no complex math.
Talking about higher mathematics scares potential users away from this practical retirement tool. Please refrain from doing it.
The math in the Flexible Retirement Planner is no more complex than anywhere else. The code does offer a more complete array of user options.
Best Wishes.
In the original comment you stated that a mix of 75% equities and 25% corporate bonds was an optimal asset mix. Remembering Professor Wm. Sharpe on this subject, he came up with the mix of 64% equities and 36% fixed income. This ratio had the best return with minimal risk. The risk factor was barely more than a 50/50 portfolio but with obvious chance for further gains. (Investors and Markets. 2007)
Do you have a reference to your 75/25 ratio?
Once again, thanks.
It's been years since I read the Trinity study in detail. However, I believe the 75/25 equity/bond mix comes directly from the Trinity professor's study. Check the Link that I referenced in my opening post.
Thank you for your support. With you, Davidrmoran, and me, we just might be approaching a critical mass. Hooray!
Best Wishes.
I like the same thing about calculators you do --- enter data, click button.
I agree you can run the car without looking under the hood.
In fact, I made that exact analogy in an earlier post when I remarked that you need not be an auto mechanic to effectively drive a car, just like you need not be a mathematician to run Monte Carlo simulations. But the more you do understand it, the more effective will be your applications.
Some wiz kids are now using Monte Carlo codes to make more informed betting decisions. And the world continues to change.
Best Wishes.
I wanted to gather some best idea here:
1. Work out a budget, revise as necessary... long term success to your investment portfolio is figuring out how to live well without overspending your wealth. (Dex, Junkster,hank)
2. Segregate 4 years of spending into "near cash investments". (Dex)
3. Run simulators or use some kind of spreadsheet software (excel) to track different financial scenarios. (MJG and Davidmoran)
4. Strive for high returns with reasonable risk. Review risk and return as often as you re-balance your portfolio. (JohnChisum)
6. Be realistic about performance (5% - 7% for long term investments) and (0% - 4 % for shorter term investments). (Many)
7. Costs matter... expense ratios, loads, transaction fees and taxes all matter... so pay attention to costs and substantiate why you pay them.
8. Prepare for the unexpected costs increases such as healthcare, LT care and overall inflation. (Catch22)
9. Stay healthy (Junkster), wealthy (Ted), and
aguy(OJ)Thank @bee for that roundup.
If we all get near 7% longterm from this high point, we'll be lucky indeed.
When I run the calcs, most of the time I put in 10% below my actual nut as of CoB.
>> politely suggest that my commentary might be modified,
haha, a motto for this group.
I too do not have anywhere near 4 years of immediately available.cash.
But I do have the equivalent of 4 years cash in a very low cost short term corporate bond mutual fund with easy access. There is some small risk there, but I have used that resource in an emergency situation with very acceptable results.
Best Wishes.
Congratulations. And, having just watched (yet again) an old episode of Star Trek: "Live long and prosper!"
Best regards- OJ