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February 13, 2005

Deciding On A Retirement Account Withdrawal Rate

It’s probably one of the most important decisions you’ll make when you retire — how much to withdraw annually from your retirement assets. Take out too much every year and you may have to seriously reduce your standard of living late in life or even deplete your assets. Take out too little and you may unnecessarily reduce your standard of living so you won’t enjoy your retirement.

Several factors need to be considered when calculating your withdrawal rate, including your life expectancy, expected long-term rate of return, expected inflation rate, and how much principal you want remaining at the end of your life. Unfortunately, life expectancies, rates of return, and inflation are difficult to predict over a retirement period that can span decades. Keep these points in mind:

  • Your life expectancy. While it’s easy enough to find out your actuarial life expectancy, life expectancies are only averages. Approximately half the population will live longer than those tables suggest. How long close relatives have lived and how healthy you are can help you gauge your life expectancy. Just to be safe, you might want to add five or 10 years to that age. After all, you don’t want to run out of money at age 75 or 80, when you might not be able to return to work.

  • Rate of return. Expected rates of return are often derived from historical rates of return and your current investment allocation. Historical rates of return are averages of returns over a period of time. You might want to be more conservative than that, assuming a rate of return lower than long-term averages. Even if you get the average return correct, the pattern of actual returns can significantly affect your portfolio’s balance. For instance, if you experience higher returns in the early years of retirement when your portfolio balance is higher and lower returns in the later years when your portfolio’s balance is lower, you’ll have a higher balance than if the opposite occurred. One of the most devastating scenarios for a retiree is to experience a severe market decline right after retirement.

  • Expected inflation. While inflation has been relatively tame recently (2.5% over the past 10 years), that has not always been the case. Over the past 30 years, inflation has averaged 4.9% (Source: Bureau of Labor Statistics, 2004). Even at tame levels, inflation can have a dramatic impact on your money’s purchasing power. For instance, at 2.5% inflation, $1 is worth 78¢ after 10 years, 61¢ after 20 years, and 48¢ after 30 years. Since your retirement is likely to last decades, use an inflation estimate encompassing a long time period.

So what is a reasonable percentage to withdraw on an annual basis? One study looked at that question based on actual market returns from 1926 to 1976. The study concluded that to ensure your assets lasted for 50 years, your initial withdrawal rate should be no higher than 3% to 3.5%, with subsequent withdrawals adjusted for inflation. To ensure assets last 30 years, the initial withdrawal rate could increase to 4%. These withdrawal rates assumed a stock allocation of 50% to 75% of the total portfolio. Due to the possibility of a major market decline soon after retiring, the study did not recommend stock allocations over 75% (Source: Journal of Financial Planning, March 2004).

Another study took a different approach to this question. By adding other asset classes to the portfolio, including international equities and real estate, and establishing fixed rules for rebalancing the portfolio, this study concluded that to last 40 years, the initial withdrawal rate could be 4.4% with a 65% weighting in equities and 5% with an 80% weighting in equities. If the retiree was willing to forego increases in withdrawals in certain circumstances, such as when the portfolio’s ending balance is lower than its beginning balance, and cap inflation increases to 6%, withdrawal rates could increase to 5.1% to 5.8% (Source: Journal of Financial Planning, October 2004).

What conclusions can be drawn from these studies?

  • Your withdrawal percentage should be modest to ensure you don’t deplete your assets. While the two studies reach different conclusions, they advocate initial withdrawals of modest amounts ranging from 3% to 5.8%. With a $1,000,000 portfolio, that means your initial withdrawal will range between $30,000 and $58,000. You need to carefully look at your assumptions before deciding between the high or low end of these estimates.

  • Stocks need to remain a significant component of your portfolio after retirement. Both studies were based on stock allocations of at least 50% and up to 80% of the total portfolio. With lower allocations to stocks, you would need to decrease your withdrawal percentage even further.

  • Review your calculations every year. This is especially important during your early retirement years. If you’re depleting your assets too rapidly, you can make changes to your portfolio, reduce your expenses, or consider going back to work. As you age, your options tend to become more limited.

  • Work as long as you can. Supporting yourself for a retirement that could span 25 or 30 years requires huge sums of money. Consider working at least a couple of years longer than originally planned. During those years, you can continue to build your retirement assets and delay making withdrawals from those assets. Once you do retire, consider working at least part time to reduce withdrawals from your retirement assets.

Review Your Social Security Statement

The Social Security Administration automatically mails Social Security statements to all workers age 25 and older who do not yet receive benefits. The statements arrive annually, approximately three months before your birthday, and contain the following information:

  • Your estimated retirement benefits at age 62, full retirement age for Social Security purposes, and age 70. These benefits are stated in current dollars and do not reflect any cost-of-living adjustments that may apply before you retire.

  • Estimated disability benefits if you become disabled immediately.

  • Estimated survivors benefits for your children and spouse if you die in the current year.

  • Your Social Security and Medicare earnings since you started working.

When you receive your statement, make sure to:

  • Check your earnings record carefully.

    Your benefits are based on your reported earnings, so check all your earnings carefully. Any errors should be reported to the Social Security Administration.

  • Use this estimate when planning your retirement.

    The statement provides the Social Security Administration’s best current estimate of your benefits when you retire. This is one factor you should consider when planning for retirement.

  • File the statement with other important documents.

    If something happens to you, this statement will give your family a good estimate of the benefits they can expect.

What About Disability Insurance?

While most people understand the need for life insurance, the need for disability income insurance is less widely understood, probably due to several misconceptions:

  • Misconception: Your odds of a long-term disability are small.

    REALITY: At all age groups, the odds of a disability are higher than the odds of death. Every year, 12% of U.S. adults incur a long-term disability. One of every seven workers will have a long-term disability lasting five years or longer (Source: Money Central, 2004).

  • Misconception: You don’t have to worry about a disability because you work in a safe profession.

    REALITY: Accidents outside of work and lingering diseases are estimated to cause 60% of disabilities (Source: National Safety Council, 2004).

  • Misconception: Social Security will pay disability benefits.

    REALITY: The criteria for Social Security benefits are very strict — your disability must be so severe you are unable to engage in any substantial gainful activity and the disability must be expected to last at least one year or result in death. Approximately 60% of claims are denied (Source: Gale Group, 2004).

  • Misconception: You have sufficient disability coverage at work.

    REALITY: Many employers only provide short-term disability coverage, typically lasting four to six months. Even if you have long-term coverage, make sure the benefits are adequate. When assessing benefits, keep in mind you must pay income taxes on any benefits paid by your employer. If you pay the premiums, the benefits are income tax free.

  • Misconception: You won’t need much income during a disability, because work-related expenses and taxes would decrease.

    REALITY: While some expenses are likely to decrease, others, such as medical and rehabilitation expenses, are likely to increase.

  • Misconception: You can always purchase disability income insurance later.

    REALITY: Once you are disabled, you won’t be able to purchase insurance. You could also develop a health problem that will prevent you from obtaining this insurance. Disability income insurance becomes more expensive as you grow older.

Mutual Fund Basics

There are basically two ways to invest your money, either do-it-yourself or hire someone to do it for you. If you decide to hire an outside money manager, one of the most popular investing vehicles is the mutual fund. The first step in selecting an appropriate fund is being sure you understand the basics.

Mutual funds are based on the concept of “mutuality” whereby many small investors pool their money together and hire an outside money manager that they normally may not have been able to afford on their own. The mutual fund company issues shares to the many different investors that represent their pro-rata ownership of the fund. If the mutual fund company, also called an investment company, continually accepts new investors and issues new shares, they are referred to as an “open-end fund”. If they only issue a finite number of shares they are referred to as a “closed-end fund”. The day-to-day value of the shares, called the Net Asset Value (NAV), is based on the value of the underlying securities less any expenses.

There are many different types of mutual funds. Funds may be comprised of investments in stocks, bonds, real estate, or even a mix of the various holdings to create “balanced” funds. You should first read the fund’s prospectus, which is the official document that details what types of investments the fund is allowed to make for its shareholders. Then, depending on your investment objective, you can determine if the fund is appropriate for you. Whether you are a conservative or an aggressive investor, you should have no problem finding an appropriate fund. There are literally thousands of funds from which to choose.

Since investing in a mutual fund is essentially hiring a money manager, you will also have to pay the money manager. Depending on how a fund is distributed, or sold, funds are usually broken down into two large categories: “load funds” and “no-load funds”. Load funds are typically sold through a third party intermediary, such as a stockbroker, insurance agent, or bank; while no-load funds are distributed directly by the money manager. Since load funds are sold through a third party, there is an extra fee to compensate the salesperson.

All funds, load or no-load, have an internal fee called the expense ratio. This is how the money manager gets paid and it is the first and most important fee of which investors should focus. The expense ratio, which may fluctuate anywhere from approximately .30% - 2.0%, is assessed annually, forever, on the entire account. This fee is what ultimately costs investors the most money and therefore should be looked at closely. Other fees, such as 12b-1 distribution fees, may also be imbedded in the expense ratio fee.

Load funds, since they are sold through representatives, will typically have either an “up front” or “back end” fee that may range anywhere from approximately 1.0%-5.75%. Also, it is only assessed initially on the new investment money and it is used to pay the salesperson. This is usually referred to as an A or B share. In recent years the C share has been invented, which usually has no up front or back end fee, but instead assesses an extra annual fee on top of the normal expense ratio. Also in recent years some investment advisors have begun offering investors no load funds but then “wrapping” an extra management fee around the fund to compensate them for their services.

The bottom line on fund basics is that if you have money to invest and do not want to make all the investment decisions on your own, you may want to use a mutual fund as the investment vehicle to reach your goals. Or if you need a lot of advice, you should probably purchase a load fund through an Investment Advisor. If you feel you understand some of the basics such as the different types of funds and their uses, you may want to invest in a no-load fund so as to reduce your expenses. Regardless of the method, if you have chosen well-run funds with reasonable expenses, good track records, and funds that are appropriate for your investment objectives, there is a very good chance you will earn a competitive rate of return on your investment over the years.

February 1, 2005

Using Diversification to Control Portfolio Volatility

The past few years have taught investors the meaning of volatility in investing. While investors weren’t that concerned about volatility before 2000, when it worked to their advantage, the negative volatility of the past few years has been much tougher to deal with.

It has pointed out the necessity to look beyond average rates of return to the volatility of those returns. Even if your projections for the average rate of return are correct, the pattern of those returns will affect your ending balance. It is the compounded annual rate of return over your investment period that will determine your portfolio’s ultimate balance, not the average rate of return. For instance, consider the performance of the Standard & Poor’s 500 (S&P 500) for the period 1997 to 2003. Annual returns were 33.4% in 1997, 28.6% in 1998, 21.0% in 1999, -9.1% in 2000, -11.9% in 2001, -22.1% in 2002, and 28.7% in 2003, for an average annual return of 9.8%. However, during the same period, the compounded annual rate of return was 7.6%, 2.2% lower than the average return.*

Periods of loss, especially toward the end of your investment period, can seriously erode value. Subsequent gains then have to first restore the lost value before principal begins to grow again. For instance, to overcome a 25% decline in an investment, you need a gain of 35%. While you want to find ways to control volatility in your portfolio, you probably don’t want to totally eliminate it, since volatility is typically rewarded with higher returns. Your objective should be to remove uncompensated risk from your portfolio and then find an acceptable level of risk and return.

Some points to consider when diversifying your portfolio include:

  • Make sure to hold a broadly diversified portfolio of stocks. A recent study of stocks from 1960 to 2001 found that diversifiable risk has increased substantially over that period. Thus, it will generally take a portfolio with a larger number of stocks to achieve adequate diversification. This study found that holding 25 stocks reduces diversifiable risk by 80%, 100 stocks reduces diversifiable risk by 90%, and 400 stocks reduces diversifiable risk by 95% (Source: AAII Journal, July 2004). These reductions are compared to the risk of holding a single stock.

  • Hold both stocks and bonds in your portfolio. Stocks tend to have a low positive correlation with corporate and government bonds, meaning on average, movements in stock prices will only moderately impact movements in bond prices. For instance, in 2002, the S&P 500 had a return of -22.1%, while long-term government bonds returned 17.8% and intermediate-term government bonds returned 12.9%.* Thus, owning both stocks and bonds reduces your portfolio’s overall volatility.

  • Evaluate new investments carefully. Make sure they add diversification benefits to your portfolio before purchasing them. You don’t want to keep adding similar investments, such as several stocks in the same industry. Not only does that not add much in the way of diversification, but it makes your portfolio more difficult to monitor.

  • Rebalance your portfolio annually. Since your asset allocation strategy is designed to provide a stable risk exposure, your portfolio must be periodically rebalanced so the allocation does not get out of line. Your portfolio may become more risky if one asset class starts to dominate your portfolio.

  • Call for an evaluation of your portfolio. The importance of a properly diversified portfolio has become apparent during the past few years. Yet, it has also become apparent that it is now more difficult to ensure your portfolio is properly diversified.

* Source: Stocks, Bonds, Bills, and Inflation 2004 Yearbook, Ibbotson Associates. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment.


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