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Make Your Retirement Dreams Come True With Our Buy-and-Hold Strategy
by Paul A. Merriman
Publisher and Editor
I’m going to assume for the sake of this article that you are familiar with the global mix of assets we use in our world-class buy-and-hold strategy. This strategy divides equity assets equally between U.S. and international stock funds, and within each half diversifies into big-cap and small-cap stocks, and divides each of those categories into growth stocks and value stocks. (This can increase your returns and reduce your risk at the same time.) I think that’s a fabulous combination.
This month I want you to look with me at three tables. The first shows, for seven variations of our strategy, the hypothetical growth of an annual $10,000 investment, from 1970 through 2000.
For each variation, we show how much you could have withdrawn in your first year of retirement (we assume that year is 2001) if you simply took out 6 percent of your fund’s year-end balance at the end of 2000.
The second and third tables show hypothetical results over the same 31 years if you had retired at the end of 1969 with $1 million and started living on either $60,000 or $80,000 a year, increasing the withdrawal annually by 3.5 percent to help offset inflation.
Let’s start with Table 1. If you’re used to looking at our tables, you’ll immediately notice that this one looks different: It doesn’t have as many numbers as most of them do. There are two reasons:
If you scan down the column of years, you’ll see that we included the figures for only even-numbered years. We did this to conserve space. You can get the information you need from this table without seeing every single year.
Scan across the top line and you’ll see that we didn’t include every percentage variation. We left out the columns for 10, 30, 70 and 90 percent equity weightings.
We have tried to make this table easy for you to use. The far right column shows the cumulative amount you would have put into this strategy at the rate of $10,000 at the start of every year. At the end of 2000, you would have put in $310,000.
That is a lot of money, more than many people set aside for retirement. But for many people, especially working couples who have reached their 30s, annual savings of $10,000 are not out of reach. And the rewards can be stunning.
The very bottom line of the table shows you how much money you’d have to live on this year if you had simply withdrawn 6 percent of your 2000 year-end balance. That is certainly a safe, conservative withdrawal rate, so it’s a realistic way to measure the real-life results of these combinations. You’ll notice that after 31 years, it makes a huge difference how much you have invested in bond funds and how much in equity funds.
When I studied this last line I imagined myself as the investor who had done this, and I kept thinking about that $310,000. And I saw that if I had invested as little as 40 percent in equities, I could take out in just one year more than half of all the money I had put in over 31 years. And if I had invested 80 percent of my money in equities, I could take out in one year more than all the money I had invested in 31 years.
Of course we don’t know what returns this strategy will achieve in future years. But I am confident that there’s an extremely high probability that you could keep withdrawing the amount in that last line every year in retirement with very little risk of running out of money. (That of course assumes that you retained the same mix of equities and bonds in retirement as during your accumulation phase.)
To me, the numbers in that bottom line of this table are very good news. Consider somebody who invested in the 60 percent equity mix for the past 31 years. During this time, there was a 12-month period when the investor had to watch the account balance decline by 20.4 percent. That isn’t comfortable, but many people could tolerate that. Based on a 6 percent withdrawal, this mix produced a first-year retirement income of $225,371 in the year 2001.
I do not know many people who truly need $225,000 every year in order to live comfortably in retirement. Therefore I think it’s reasonable to assume that this withdrawal rate has some built-in cushion. That’s a margin for error, if you will, that gives me some extra confidence in recommending such a strategy.
And consider this: Even if at the start of this year (2001), that investor put the whole account in a money-market fund with no risk at all, assuming a 5 percent return, he or she could keep drawing out $225,000 for more than 30 years before the money would be gone. I’m not advocating that, but it’s interesting to see.
Table 2 shows what happened if you started with $1 million at the end of 1969, held out $60,000 on which to live in 1970, and then increased your withdrawal every year by 3.5 percent.
This may look like Table 1, but it’s really quite different. To understand it, think of the question that we wanted to answer: Would the annual returns of this strategy support a retired investor who could live on 6 percent of the initial portfolio, with 3.5 percent annual increases to offset expected inflation?
To answer that, we assumed the same $1 million starting pool at the end of 1969 and the same withdrawals each year, which you see listed in the far left column. Over this time period, none of these variations on our strategy ran out of money. (But if you look at all-fixed-income portfolio, you can see it could not last through 2001 .)
This table is useful if it helps you to see a combination of fixed-income and equity funds that would be appropriate for you. So the point is to find a column with the right combination of returns and risks.
Here are two things in this table that stand out for me.
First: In every column, the year-end balance fell below the original $1 million at some point. That had to be uncomfortable for a retired investor counting on this money for living expenses. So one exercise is to run your finger down each column and look for the smallest number. Ask yourself if that is so low that you’d be tempted to bail out. For instance, the lowest point in the 20 percent equity combination was $983,613. That should be easy to live with. But in the 100 percent equity column, the balance fell at one point to $753,317, a loss of about 25 percent. (We’ll discuss the numbers in the all-fixed-income portfolio in a moment.)
Second, because the withdrawals for living expenses were the same in every column, there is only one result that varies among columns: the amount of money left at the end of 2000.
It’s obvious that in the columns from 50 percent up through 100 percent equities, the portfolio has grown so much that these programmed withdrawals are not likely to seriously erode it. If you retired with any of those portfolio mixes, you could live well and leave a substantial estate.
Now I invite you to turn your attention to the 20 percent equity column, which ends 2000 with "only" about $2.5 million. Is that column likely to be jeopardized in the future? Obviously we can’t know future returns.
But recall that back in 1970, this investor began by taking out 6 percent of the portfolio’s year-end (1969) balance and survived 30 years of increasing withdrawals just fine.
Could the 20 percent equity column continue doing that for another 30 years? In our scenario, the withdrawal for the year 2001 would be $174,302, or only about 6.9 percent of the year-end balance in 2000. That leads me to believe that this investment mix could continue supporting these increasing withdrawals for awhile — but maybe not indefinitely.
The picture in the all-fixed-income strategy is not pretty. Scan down the column and you’ll see that the year-end balance never rose much above $1 million. Its high point came at the end of 1986, $1.3 million. Starting in 1994, this portfolio began sinking rapidly. The problem was not inadequate bond returns in the 1990s; they were fine. The problem was the relentless increase in the withdrawals.
This portfolio could sustain itself in the 1980s when interest rates were falling and total returns on bonds were abnormally high – and when the investor’s withdrawals were less than 10 percent of the portfolio balance. But by 1991, the withdrawal was 10.6 percent of the 1990 year-end balance. That percentage rose by 1993 to 12.4 percent of the previous year’s balance. The 1995 withdrawal of $141,795 was one-sixth of the portfolio value. As withdrawals continued to rise, it was all downhill from there.
My conclusion from this table is that it’s prudent to have at least 25 to 30 percent of an investment portfolio in equities in order to take out this level of withdrawals. If you can tolerate having at least half of your portfolio in equities, you can probably count on living well and leaving a legacy.
For some investors, taking out 6 percent initially ($60,000 in our example) is not sufficient. So we constructed Table 3, based on an assumed 8 percent withdrawal, starting with $80,000. Otherwise, this is identical to the table that we just studied.
You’ll see instantly in Table 3 that this higher rate of withdrawal, with 3.5 percent annual increases, didn’t work so well unless you had a higher weighting of equities – and unless you had global diversification beyond the S&P 500 Index. That index, until recently so popular that many investors believed it was all they needed, runs out of gas pretty dramatically in this table.
As you can see, the all-fixed-income, 20 percent and 40 percent equity portfolios could not keep up with this level of withdrawals. And you can see that the 50 percent equity column is doomed: the withdrawal for 2000 took 27 percent of the 1999 year-end balance. The 2001 withdrawal of 232,402 would take 39 percent of the 2000 year-end balance. This year’s withdrawal would amount to 9.7 percent of the 2000 year-end balance for the 60 percent portfolio. It is not in immediate danger. But that does not leave enough margin to make me comfortable in assuming that this portfolio could keep up with the ever-increasing withdrawals for another 30 years.
My conclusion from this table: If you must take out 8 percent of your portfolio for annual living expenses (increased each year by 3.5 percent), you’d better have 80 percent or more of your assets in equities. And as you can see from the balance at the end of 1974, you had better be prepared to tolerate your portfolio shrinking temporarily (you hope!) by anywhere from 28 percent (in the 80 percent equity column) to 34 percent (in the all-equity column), when compared with your initial $1 million balance.
The main point I want to leave you with is how superior the globally diversified strategy is when it’s compared with the Standard & Poor’s 500 Index. You can see that in each of the tables in this newsletter.
You can also see there’s a big difference between a withdrawal rate of 6 percent and one of 8 percent. When you’re planning for retirement, I suggest you assume a conservative withdrawal rate – something less than 8 percent.
If you can meet your needs on withdrawals of 5 percent per year, you should have few worries. But that requires more assets than many people will accumulate. I’d suggest you try to make the numbers work at 6 percent, and don’t assume you can go higher than 7 percent.
If this means you must work another year or two before retirement, the added peace of mind may be worth it. And another plan worth consideration is working part-time in your first few years of retirement. That way you might be able to start out with withdrawals of 3 percent or 4 percent, and let your portfolio grow a bit more before it starts shouldering the whole load of your needs.
One terrific question you may be asking yourself right now is: "How much confidence can I have in these numbers?"
There’s nothing guaranteed about these numbers, because they are all from the past. The future will be different. But basic relationships are not likely to be different. You’ll still get higher returns and higher risks from combinations that include more equities, and vice versa. I think you should assume with every combination that you will be exposed to the level of risk shown in that column. And I think you should count on getting no more than 90 percent of the returns from each column.
That means you might have to plan on a higher level of equities in your portfolio, or a lower level of withdrawals. If you make a conservative plan you may find yourself getting higher returns than are absolutely necessary to meet your needs. If that happens, don’t complain! Personally I always prefer to err on the side of being conservative than the other way around.
Here’s a motto that works for me: "Hope for the best, but be prepared for the worst."
Life always has surprises for us. And when you have choices, I believe it’s better to run your life so you are more likely to be pleasantly surprised than to be unpleasantly surprised.
I’m confident that if you use this buy-and-hold strategy and stick with it, you’ll be pleased with the results.
Source: http://www.fundadvice.com
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