The principle of preservation over accumulation
Perhaps the main key to successful retirement income planning is the principle of preservation over accumulation. Understanding this key point can reorient you in a way that may guarantee success in retirement.
To fully grasp this, one must begin by understanding the threats to any retirement. They are, in no particular order, longevity, market risk, inflation, taxes, fees, probate, health care, and long-term care. There are others, of course, but these are the items we tackle most frequently. And they are the places where there are opportunities to keep more of what you have.
Starting with longevity, this is the most challenging, yet easiest to solve, roadblock to a worry-free retirement. More people fear running out of money before they die than fear death itself. With good reason. The current standard for managing money for retirement income utilizes an extremely risky approach which is backed by nearly meaningless tools. The approach is the market, and the tools are outdated withdrawal guidelines, the 4 percent rule, and inappropriate analysis tools, Monte Carlo Analysis.
But if everyone is using these, how can I, in this lonely little column, be calling them all out for being wrong? Simple. Because they are.
Think about it. Everything we hear about the market indicates average returns of anywhere from 7 percent to as much a 12 percent annually. Yet what is the accepted income payout from these accounts making 7 percent to 12 percent? The maximum, which has been under attack now for the better part of a decade, is 4 percent. Today, it’s around 2.8 percent. That’s just less than half the amount we are supposed to be collecting in interest. But that’s the rub, isn’t it? It’s not interest. Interest is an agreed-upon amount paid on protected principal that gets added to and becomes part of the principal every year. A true interest payment of 3 percent would provide a guaranteed withdrawal rate of 3 percent. But that’s not what really happens.
What really happens is the market goes up one day, maybe several days, or even weeks or months. That means the value of your holdings appreciates. But it doesn’t lock in and become part of your principal. If you are cashing in for income during this time, it’s working out for you and you are selling the gain. But it could just as easily be down tomorrow, or even weeks or months. And since you need money to pay your bills, you are likely going to have to sell the dip, thereby locking in the losses. Worse, you need to sell more shares than you otherwise would have, and so you have fewer to recover with, if and when the market goes back up.
Unlike a fixed product with an agreed-upon interest rate, we have no way of knowing. So, the conventional wisdom is to reduce payouts to such a small level that we are insulated from huge declines like what we saw in the 2000s.
This may be somewhat effective in helping our money last, but it’s extremely inefficient, as is underscored by Monte Carlo analysis. What is Monte Carlo other than a huge destination for gambling? Monte Carlo Analysis is a stochastic (randomly determined) methodology for testing outcomes in certain conditions. It was developed during the 1940s for use in the Manhattan Project. What you do is put in a bunch of measurable inputs, model an activity a thousand or more times, and tally the results. It turned out to be a very useful tool when you had a controlled experiment with a clear idea of all the inputs. First, they would set up a certain set of conditions such as temperature, pressure, various elemental compounds, electrical charge, blunt force, you name it. Then, they would observe the outcomes of these various stimulants and conditions on atomic particles. By observing, logging, and analyzing, they were able to derive very accurate and valid statistical models that were successfully used in building the first atom bomb.
However, Monte Carlo has not had the same success in financial planning. That’s because there are far too many variables. About the only thing you really know is how much money you have to work with. You have no idea what the rate or sequence of returns is going to be, what taxes and fees you will have to pay, how often the market will turn down or up, how severe those turns will be, or how long you will need the money for. So, we are relegated to starting with the aforementioned 4 percent to then be tested by the Monte Carlo run, which is incredibly imprecise.
Here’s an example. I just ran a Monte Carlo on a couple with $1 million in retirement savings and $64,000 a year in projected Social Security benefits. Their total need was $95,000. Subtracting the $64,000 from the $95,000 left $31,000 in initial income needed, with a 3 percent annual inflation rate. So we were starting with a 3.1 percent needed income, which is right in the target area.
The results of the Monte Carlo plan, however, reflected only a 44 percent success rate, way below what is acceptable (we usually shoot for 85 percent to 90 percent). Even less satisfactory, however, was the range of outputs. In this case, the range was completely out of money within seven years, to having nearly $30 million in the bank after 30. To me, that sounds like a pretty useless data set.
The answer is to get out of the market and into an interest-bearing retirement income generator (RIG) that will provide a contractually-guaranteed amount of income. Only when you have an income stream that is predictable and reliable can you craft a plan you can count on. In future columns we will examine various types of RIGs and how they work.
Stephen Kelley is a recognized leader in retirement income planning. Located in Nashua, he services Greater Boston and the New England areas. He is the author of five books, including “Tell Me When You’re Going to Die,” which deals with the problem unknown lifespans create for retirement planning. It and his other books are available on Amazon.com. He can be heard every weekend on the “Free to Retire” radio show on WCAP and WFEA, and he conducts planning workshops at his New England Adult Learning Center, located in Nashua. Initial consultations are always free. He can be reached at 603-881-8811 or at www.FreeToRetireRadio.com.