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Our Owner, David Wertz is Retiring so we are no longer taking clients
In retirement you will use you savings to pay your expenses. However, As we discuss in our Retirement Planning page you will probably be in retirement a long time. Thus, you need to balance the desire to have as much money as possible to maintain your standard of living with the need to make sure that you do not outlive your savings. In this page we discuss the factors that go into finding this balance and make some suggestions on how to find the balance that is right for you.
Our Retirement Planning page also points out that because NO ONE can reliable predict the future, your retirement plan needs to have a "Margin of Safety" to deal with the unexpected when, not if, it occurs.
Incorporating an Inflation "Margin of Safety" into Your Retirement Investment Strategy
Inflation is a major problem in retirement. The Federal government has said that it wants a minimum of 2% inflation. At 2% inflation your pension and savings will lose 46% of their value over a 30 year retirement. At average inflation over the last 100 years both your pension and savings will lose 64% of their value in terms of what they will buy during the course of your retirement.
The biggest factor in determining how much money you will have to pay your expenses in retirement is how you invest your savings. In Table 1 we summarize both the historical returns on various types of investments but also how good a job each type of asset does at protection you from inflation. Table 3 at the end of this page gives some of the information used in coming up with the summary information in Table 1.
How Much Money Can You Spend Each year in Retirement?
As Table 2 below shows, the answer to this question that it depends on
In interpreting Table 2 below it is useful to remember that on our Retirement Planning page we advise that the "Margin of Safety" answer to the question "How long will I live?" is that age 65 there is a 50% chance one member of a couple will live 30 years to age 95. In addition, Table 1 above includes a summary of what different asset types earn which helps make the numbers in Table 2 more meaningful.
I want to use the information in Table 2 to make three important points.
Applying the Ideas in Tables 1 and 2 to Real Life
While Table 2 shows the BIG advantage of investing your retirement savings in common stocks and real estate it ignores an equally BIG complication. Namely, that the prices of both real estate and especially common stocks fluctuate greatly from year to year. For example, the year-to-year fluctuations in the stock market are usually in the 10% TO 30% range but fluctuations greater than 30% occur periodically.. This means that if you use the percentages in Table 2 to determine how much of your savings you spend each year, the amount you are able to spend will fluctuate wildly from year-to-year. Table 3 below, however, shows that when these fluctuations average out over your retirement. Unfortunately, if you rely on Table 2 or a similar method to determine how much is available to spend each year the fact that these fluctuations will average out over your 30 year retirmement is not much help in making each year's budget.
It is these year-to-year fluctuations in stock prices that have given common stocks a reputation of being risky and it has also given rise to the "conventional wisdom" that their role in the retiree's investment account should be limited -- by the retiree holding a substantial amount of bonds. While the prices of bonds do not fluctuate as much year-to-year as stocks, Table 3 below shows that over the long the long run inflation makes bonds less predictable and thus more risky than common stocks and real estate.
Thus, while we reject the conventional solution to stock market fluctuations -- bonds, we do realize that the large changes in stock prices have to be dealt with. Our solution is to go back to basics and realize that stocks have a value over the long term not because you can sell them today for some price but because of the earnings of the companies whose stocks you purchase over the long term. The same is true of real estate -- it it real estate's long term earnings that give it value. Thus, we recommend that you base your withdrawals from your savings not on the current value of your retirement account, which fluctuates unpredictably from year-to- year, but on the 10 year average earnings (inflation adjusted) of the assets in your account. This earnings based approach is quite different from the conventional approach, as exemplified by Table 2, where the amount the retiree withdraws is based on the value of your savings.
Yale Professor Schiller has compiled the earnings, prices , P/E ratios and other data about stocks starting in 1870 and publishes this data. One of the things in this data set is the 10 year average inflation adjusted earnings of the stock market as a whole. If you divide that P/E ratio into the current value of your common stock account you will get the average income that your stocks will produce. Then you or your financial advisor can use this income number plus your "Margin of Safety" life expectancy and what are known as annuity calculation to determine the maximum amount that you can safely spend each year.
The idea for dealing with stock price fluctuations should also be applied to real estate investments. Unfortunately, doing so is more difficult for real estate because there is no equivalent to the Schiller data. I recommend that instead you base your decisions on the 10 year average earnings based on income from rent alone for the properties that you own. If these numbers are not available then use the numbers for similar properties. Fortunately, this information is available for publically traded REITs.
Even with Our Earnings Based Approach Your Still Need a Margin of Safety
History says that the 10 year average earning based approach we advocate will do a MUCH, MUCH better job of providing a stable, predicable income but not a not do a perfect job. Even when averaged over 10 years the earnings of both companies and real estate still fluctuate in the range of 2% to 3% per year. Compared to the 10 times larger fluctuatuions in stock and real estate prices these might seem to be too small to worry about. Unfortunately, the right most column of Table 2 shows that even fluctuations this small will have a substantial impact over the course of your retirement. What needs to be done in response to these fluctuations in 10 year average earnings depends on your retirement "Margin of Safety" strategy.
If your "Margin of Safety" strategy is to spend only the income produced by your savings then the income number calculated above from your socks and real estate investments is sufficient. Namely, the 10 year average earnings will be your budget for the next year and because changes are phased in over a 10 year period you will have plenty of time to adjust to these changes.
However, if you are have decided that your strategy will be to spend both income plus some principle each year then you need to use an approach that combines the average earnings number plus your "Margin of Safety" life expectancy and what are known as annuity calculation to determine how much you can safely spend each year. Unfortunately, these annuity calculations are based on the assumtption that the return on your savings will be the same over your entire retirement. As pointed out above, such a prediction can never be reliable -- even with our 10 year average earnings approach. Thus, you need to revisit your financial advisor periodically, say every 5 years or so to readjust both the annuity calculations and your plan to the reflect current situation.
A Further Note About Bonds
We recommend against the retiree holding long term bonds because inflation makes them risky. We also encourage the retiree to realize that when used the way we describe above that stocks and real estate are not as risky as commonly believed. However, this does not mean that we believe that ALL of a retiree's savings should be in stocks and real estate. Given the year-to-year fluctuations in prices of stocks and real estate the retiree needs a portion of their savings to be in something with a stable value. The retiree also needs money in something with a stable value for an emergency fund. The amount in stable value investments will vary with the retiree circumstances and objectives. However, we stongly advocate that this stable value portion be kept in cash and cash equivalents instead of long term bonds or other so called "fixed income" assets.