You want to retire soon. What is the best way to setup your retirement income to give you the maximum income that will reliably last the rest of your life?

Many financial planners use the “4% Rule”, which says that you can, for example, withdraw $40,000/year plus inflation for life from a $1 million portfolio. Is that safe?

I studied 146 years of investment history. The conclusions are surprising:

  1. Most of the advice seniors are given is not supported by history.
  2. I found what really works to give you the maximum reliable retirement income – both how to setup your portfolio and manage your income.

 

“Conventional wisdom”

Let’s look at the typical advice given to seniors about to retire:

  1. Invest conservatively because you can’t afford to take a loss.
  2. The “4% Rule”: You can safely withdraw 4% of your investments and increase that by inflation for the rest of your life.
  3. Invest conservatively because you can run out of money because of the “sequence of returns”. A few bad years shortly after you retire can sink your retirement.
  4. Try to live off the interest and don’t touch your principal.
  5. Don’t invest more than “100 minus your age” (or 110) in stocks. This is a common rule of thumb, saying that at age 70, you should have 70% in bonds and 30% in stocks.
  6. Keep cash equal to 2 years’ income to draw on when your investments are down.

These 6 are the “conventional wisdom” advice typically given to seniors, but history shows that these are generally not the best advice.

 

146-Year Study of Sustainable Retirement Income Withdrawals

I recently did a “maximum sustainable retirement income” study. I studied 146 years of history1 to see what would have happened if you had retired each year using different withdrawal amounts, various strategies, and varying amounts of stocks, bonds and cash to answer 3 questions:

  1. How much retirement income can you safely withdraw from your investments?
  2. How should you invest to minimize your risk of running out of money?
  3. What strategies can reliably give you the highest retirement income?

 

Some of the results of my 146-year study are in the chart below. The chart needs a bit of explanation:

  • I defined a “success” in retiring as providing a reliable income rising with inflation for 30 years. That means you retire at 65 and have your money last to age 95.
  • The chart shows the odds of success at each allocation of stocks and bonds assuming different withdrawal rates plus inflation for 30 years. For example, looking at 4% withdrawal on the chart to test the 4% Rule, the success rate has been 96-97% with equity-focused portfolios, but only 47% with bond-focused portfolios. The allocation of stocks to bonds is most commonly done by selecting equity funds (stocks), balanced or income funds (typically 50% stocks/50% bonds), or a bond fund.
  • The bottom section on “Highest Success Rate” is a test of the 4% Rule. If you want to be 95% or 98% sure that you won’t run out of money, the chart shows the maximum amounts you can withdraw from your investments. For example, if you want to use the “100 minus your age” rule of thumb and have 70% bonds & 30% equities when you are close to 70, you should limit your withdrawals to 3.6% (not 4%) of your investments. 98% of the time in history, your money would have lasted 30 years.

 

Here are graphs showing the actual results in history of withdrawing $40,000/year plus inflation for 30 years with 3 different portfolios. Each line shows the portfolio value over 30 years for one retirement year. Note how often the line falls to zero:

Actual Retirement Success History – 100% Equities with 4% Withdrawal + Inflation

With 100% equities, your portfolio would only have hit zero 5 times in the last 146 years. The only failures were retiring in 1929 and in the late 1960s.

 

Actual Retirement Success History – 70% Bonds/30% Equities with 4% Withdrawal + Inflation


With the “100 minus age” rule of thumb, you would invest 70% in bonds when close to age 70. You would have run out of money retiring in 20 different years. These included a few times in the late 1800s and early 1900s, several when retiring in the late 1930s to mid-1940s, and most of the time retiring from the mid-1950s to late 1960s.

 

Actual Retirement Success History – 100% Bonds with 4% Withdrawal + Inflation

With 100% bonds, your retirement income is the opposite of safe! You would have run out of money more than half the time, including if you had retired almost every year from 1880 to 1970.

 

Results of the study

The conclusions are very useful – and surprising. The history of investments shows the following:

  1. Equities are safer! The more conservatively you invest, the more likely you will run out of money. At every withdrawal amount, the more you invest in stocks, the more reliable your retirement income. – Shocking!
  2. Fixed income is lower income. The more conservatively you invest, the lower your retirement income should be. – Not surprising.
  3. “4% Rule” – Yes for equity investors. No for income investors. – Surprising! The success of the “4% Rule” depends on how you invest:
    1. Equity investors (70+% equities) can safely withdraw 4%.
    2. Balanced investors (60/40 to 40/60) should reduce it to a “3.8% Rule”.
    3. Conservative investors (more than 60% bonds or GICs) should limit it to a “3% Rule”.
    4. Bond or GIC investors (no equities) should limit it to a “2.5% Rule”.
  4. It is safer not to hold cash. Holding cash does not protect you and may increase your risk of running out of money. It safer not to hold cash. – Surprising!

 

Holding cash to cover down years

Many financial planners recommend holding cash equal to 2 years’ withdrawals to draw on when your investments are down. The idea is that after a significant down year, you can live off the cash and not touch your investments, to give them some time to recover.

This sounds logical, but was not supported by the 146-year study. For example, assuming 100% in equities and a cash holding, here are the success rates for a 30-year retirement:

In every case, holding cash either had no effect or increased the risk of running out of money. I could not find a single example of a retiring year or withdrawal amount when holding any amount of cash provided a higher success rate than holding no cash.

The study showed that holding cash does not protect you. In fact, it often increases your risk of running out of money.

There is an argument that holding cash has a good behavioural effect on investors. With some cash, they may stay invested and avoid the “Big Mistake” of selling their equities while they are down. To the extent this is true, holding some cash may be beneficial for the behavioural effect only.

But cash does not actually protect you. It’s safer not to hold cash.

 

Reasons for the surprising results

The results of history are quite surprising, especially that investing in bonds or cash increased the risk of running out of money.

Why would stocks provide a more reliable retirement income? Aren’t they risky? What if the market crashes early in your retirement?

Let’s put some perspective on it.

The risk in retirement is running out of money. You can run out of money in 3 main ways:

  1. You withdraw too much from your investments.
  2. You invest too aggressively, your investments lose money and don’t recover quickly.
  3. You invest too conservatively, so that your rate of return is too low to support your withdrawals.

The study showed that the risk of stocks is real, but exaggerated, while the risks of bonds are much greater than most people realize.

A stock market crash early in your retirement can be a problem. Financial people call it the “sequence of returns”. However, the truth is that the stock market usually bounces back within a year or 2. Stock market losses only caused a problem over a 30-year retirement 5 times in the last 146 years.

The risks of bonds is more subtle, but far more likely to happen. You can run out of money either from interest rates being low or from inflation being high.

Bonds get killed by inflation. There have been 40-year periods of time when bonds lost money after inflation. They paid interest, but your investments pay for less of your lifestyle expenses than they did 40 years ago. The longest time like this was from 1940-1980.

Note this worst period for bonds from 1940-80 started when interest rates were very low – like they are today.

Bottom line: Stock markets are more reliable over time than most people realize. This is the reason that equities consistently provided a more reliable retirement.

 

What is wrong with just investing safely in bonds or GICs?

History shows that having 100% in bonds or GICs can mean you run out of money if you withdraw too much or if inflation is higher. If you are going to invest this conservatively, you should limit your withdrawals to 2.5% of your investments per year.  That means, for example, a $1 million portfolio can give you an income of $25,000, while it can be $40,000 or more for an equity portfolio.

Don’t forget that you will want your income to rise with inflation. You will have to cash in a bit of your principal every year, not just live off the interest.

Bottom line: Do you want a fixed income or rising income (by inflation) during retirement? Bonds and GICs are good for a fixed income, but can get killed by inflation, especially over many years. Stocks are much better at providing rising income. They tend to adjust to inflation.

 

Does your retirement income need to rise with inflation?

The part of retirement income planning that is most commonly missed is inflation. You need your income to rise by inflation.

Inflation is a huge factor over a 30-year retirement. With low inflation of 2%, the cost of living will roughly double during your retirement. Inflation has averaged closer to 4% historically, which means the cost of living roughly quadruples.

You have probably heard seniors complain about being on a “fixed income”. This is because they withdraw the interest only from their GICs. Their income is fixed, not rising with inflation. It is like getting a pay cut every year for 30 years. Your expenses keep rising, but your income is fixed.

Some advisors say that lifestyle expenses do not actually rise by inflation during retirement, because seniors spend less on travel and entertainment as they get older.

Others say this is often just a temporary lull. You may travel a lot in your 60s and 70s, then less in your 80s. But then you may move to a retirement home in your 80s, and have higher expenses. This is especially true if you want a nice, private retirement home, not a government one.

My own experience working with retirees is that, for the most part, income determines lifestyle. Those that have a good income tend to maintain a more active lifestyle. Cruises are full of people in their 70s and 80s. Those with limited income are forced to spend less.

The best advice is to plan for your income to rise by inflation. You don’t know what will happen. If you can afford to maintain your lifestyle, you will have more options throughout your life.

Planning for inflation means you can afford your lifestyle throughout your life. Remember that Income determines lifestyle.

 

Risk Tolerance

The surprising result that equities consistently provide a safer retirement than bonds or cash means we must discuss risk tolerance. In the last 146 years, investing 90-100% in equities has been the safest, but you should not necessarily invest this way.

It is still important to invest based on your risk tolerance. Most people have a fear of losing money and don’t really understand the stock market, which can lead to the “Big Mistake”.

The “Big Mistake” is selling your equity investments (or switching to more conservative investments) after they go down. This locks in your loss and does not allow your investments to recover.

You only get the retirement safety and higher return of stocks if you stay invested during the down markets.

The best way to think of your risk tolerance is your ability to avoid the “Big Mistake” in a worst-case scenario.  If you invest 50% equities/50% bonds and there is a huge 40% market crash, your investments may be down roughly 20%. Can you avoid the “Big Mistake” with a 20% decline?

It is a good idea to get educated on stock market history. Many people don’t understand it and are scared of “losing all their money” in stocks. I would suggest the largest market crashes likely to happen in your life are probably in the 40-50% range – not 100%.

The highest and most reliable retirement incomes are with 90-100% in equities, but only if you can invest effectively that way – and stick to it through bear markets. There will almost definitely be very large down markets during your retirement.

If you commit the “Big Mistake” even once, the higher returns and more reliable retirement from equities might not apply to you.

The best advice is:

  1. Have a decent exposure to equities, but within your risk tolerance. Don’t own equities past your ability to remain confident in a large bear market.
  2. It may be best to maintain the investment allocation you had just before you retired. You were comfortable with that. Most people assume they should invest more conservatively when they retire, but the 146-year study proved that increases your risk of running out of money.
  3. No matter what – never make the “Big Mistake” by selling or switching to more conservative investments after a market decline.

 

Advanced retirement income strategies

Is there a way to safely take a higher retirement income?

The main focus of my study was on choosing a withdrawal amount and increasing it every year by inflation. What if we managed the withdrawal, instead of increasing it every year?

I looked at a wide variety of ways to manage your retirement income, including only increasing by inflation in good years, having some type of cap and floor on the withdrawals, reducing withdrawals by some percent if they get too high, etc. I compared my best strategies with various studies, including several actuarial studies and some advisor formulas, such as the Guyton-Klinger strategy and the Hebeler Autopilot.

I tried to find the best formula to manage retirement income to allow a higher and safer income.

The options are complex, but I found there are effective methods that had 100% success in history with withdrawal rates of 5% and even 6% of your investments. You should be careful with these higher methods, since you will have to manage your income effectively.

 

Summary & Best advice: How to maximize your retirement income.

What is the best way to setup your retirement income to give you the maximum income with the lowest risk of running out of money?

  1. Equities are safer! Don’t assume you need to invest more conservatively just because you are retired. Retirement is for 30+ years. Consider keeping the same allocation you had before retiring. Equities are taxed at much lower rates than bonds & GICs, as well.
  2. Fixed income is lower income. The more conservatively you invest, the lower your retirement income should be.
  3. Be smart about your risk tolerance. Invest with the highest amount in stocks that is within your risk tolerance. The more conservatively you invest, the more likely you will run out of money (at any withdrawal amount). Get educated on stock and bond market history, so you have an accurate picture of risks and returns. Make sure you can avoid the “Big Mistake”.
  4. Inflation is huge. Inflation will make the cost of living double or quadruple during your retirement. You need a rising income, not a fixed income.
  5. Is the “4% Rule” safe? – Yes for equity investors. No for income investors. The success of the “4% Rule” depends on how you invest:
    1. Equity investors (70+% equities) can safely withdraw 4%.
    2. Balanced investors (60/40 to 40/60) should reduce it to a “3.8% Rule”.
    3. Conservative investors (more than 60% bonds or GICs) should limit it to a “3% Rule”.
    4. Bond or GIC investors (no equities) should limit it to a “2.5% Rule”.
  6. It is safer not to hold cash. Holding cash does not protect you and may increase your risk of running out of money.
  7. Higher income is possible with effective management. You can have a higher income by withdrawing 5% or even 6% of your investments, if you can manage your income effectively or are working with a financial planner who knows how to manage it effectively.

 

If you are concerned about how to plan for or setup your maximum reliable retirement income, get your Free 30-Minute Consultation.

 

Ed

 

1 Market history is US data since 1871 from Standard & Poors, Barclays and Bureau of Labour Statistics. cFIREsim.

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