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Safely Investing Your Retirement Savings and Using Them to Pay Your Expenses

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.

Table 1. Asset type Inflation Hedge Ratings and Average Returns
Asset typeGood/Bad Inflation hedge Reason for Rating Historic Average real, after inflation return
Cash, Savings accounts, CDs 1 year or less, ... Good While their value falls with inflation history says that the interest rate you receive usually quickly adjusts to reflect the current inflation rate. 1%
Bonds, annuities, mortgages, pensions, preferred stock Bad These assets are called "safe" assets because they have a "fixed" value. Unfortunately, the value is "fixed" only if you ignore inflation. Variable, unpredictable, on average return is 0.6% higher than cash
Common StockGood Returns vary substantially from year to year because of stock market fluctuations but over the long term (a) the income you receive does a good job of keeping up with inflation returns and (b) long term average returns are fairly constant.6.5%
Real EstateGood Returns vary from year to year but less than Stocks. Over the long term (a) the income you receive does a good job of keeping up with inflation and (b) long term average returns are fairly constant. 5% - 6%

How Much Money Can You Spend Each year in Retirement?

As Table 2 below shows, the answer to this question that it depends on

  • How long you assume you will live.
  • How much you savings earn each year.

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.

Table 2. The MAXIMUM percent amount of your savings you can spend each year depending on how long you live and the real, after inflation return on your savings.
Return 25 Years withdrawal rate 30 Years withdrawal rate35 Years withdrawal rate Reduction in how long you can withdraw money if you take 1% more of your savings each year
1%4.5%3.9%3.4%9.0 years
2.5%5.4%4.8%4.3%9.5 years
3.5%6.1%5.4%5.0%10.0 years
5.5%7.5%6.9%6.5%10.5 years
6.5%8.2%7.7%7.3%11.0 years

I want to use the information in Table 2 to make three important points.

  1. Spending the principle of your savings is very different from spending the income that you savings produce. There are two reasons for this. First, you can spend the principle only once. This is very different from spending income, which you can spend year after year. Second, when you spend principle you also lose forever the income the principle would have produced. This a significant number. For example, if your savings earn 6.5% a year over 30 years you will lose $1.95 in income over your 30 year retirement for each $1.0 you spend early in your retirement. This bring the total loss on spending $1 of principle to $2.95.
  2. It is impossible to reliably predict the earning on your savings to 1% or better. Thus, Table 2 says that your retirement plan's "Margin of Safety" strategy needs to take into account this uncertainty of what your savings will earn.
  3. In Table 1 above we show that the real, after inflation returns on stocks and real estate are the 5.0 to 6.5% range but the returns on cash are quite low, about 1%. Table 2 shows that as a result a conservative, cash only investment strategy will result in your having half the retirement income of a stock + real estate investment strategy.

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.

Appendix

Table 3. Average real, after inflation returns on three asset types investment types over selected 30 year periods.
PeriodAverage Real Govt. Bill Returns (%) Average Real Govt. Long Bond Returns (%)Average Real Stock Returns (%) Average Real Returns on Real Estate
1900 - 19302.02.35.2
1910 - 19400.21.74.2
1920 - 19500.82.38.8
1930 - 1960-0.30.46.7
1940 - 1970-0.4-1.86.0
1950 - 19800.90.57.7
1960 - 19901.52.86.8
1970 - 20001.54.47.2
1978 - 2014 6.2
Risk as measured as the difference between highest and lowest returns 2.36.24.6
100 year average return0.91.66.7 About 1% less than stocks*
Footnote: I was unable to find any reliable study of the long term returns on commercial real estate. The best I could find was one for the period after 1978 to the present. Then next best thing I could find was a consensus of "experts" that the returns on commercial real estate varied much less from year to year than stocks and that as a result investors were willing to accept about 1% lower returns.

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