1988 is here and Mary is ready to enjoy her retirement. She’s had a rough past year and can’t wait to be able to relax. Unfortunately her husband Bill has recently passed away. Bill had taken good care of her while she worked hard to maintain a household and raise their three kids. He worked very hard as well and consistently saved money. In fact his retirement account is now worth $500,000. Mary has always been the one responsible for paying the household bills but has never handled that much money at one time. She needed help.
She turned to the local financial planner. The financial planner tells her that if she withdraws 4% of her portfolio for income it will last her for as long as she lives. She does her calculations with the bills that she usually pays and figures out that she needs to withdraw $21,000 in the first year to live the way she is accustomed to. The financial planner says that should work and ties her withdrawals to an inflation rate of 3.5% so that her income will keep up with rising prices. The financial planner then invests her money in an index fund that invests in the S&P 500 with no expense ratio and charges her nothing to set this all up. (Don’t laugh it’s my story)
So how will Mary fair? What if I told you the possibilities are endless? Now we have the luxury of knowing what’s going to happen to Mary over the next 21 years. Jump ahead and it’s the end of 2008. The S&P 500 has enjoyed compounded annual growth rate of 8.8%. That’s pretty good. You’d probably guess that Mary is sitting pretty. You are right she has plenty of money and her biggest problem is how to get the money to her kids the best way possible. She actually ends up just shy or $1.8 million.
Could things have been different? What if we take the same exact returns except reverse the order? So this means that the returns of 2008 happen first and her final year would be the return from 1988. Should this make a big difference? I mean it’s the same performance right? Well what if I told you that if we did this she would have just over $14,000 left. Yes you read that right.
Now let’s look at why the big difference. The key here is the sequence of returns. This is the reality that people the have retired in this millennium might very well face down the road. By having bad performance early on, the account never quite recovers. When you add withdrawals to this it gets even worse. People are telling you today to keep putting money away. You hear about dollar cost averaging and how this will help you account bounce back more quickly. What they don’t tell you is if you are withdrawing during these bad times it’s like a double hit on your account.
This is the reality of what retirees are facing today. This is the opportunity for future retirees to learn. Learn that you don’t want your future based on the sequence of market performance. What can you take away from this? What do you think is the most valuable information?
There are really three sets of people that have some very real and slightly different problems. You have future retires that should be learning how not to have their retirement success determined by the market. Then there are people about to or who have just retired who have to figure out real quickly how to not have their success determined by the market. Finally, there are the people who have been retired that are trying to figure out how not to have their survival determined by the market. Are you noticing a pattern?
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Wow the variation in Mary’s portfolio is stunning. Thanks for sharing this stark comparison.
.-= The Financial Savvy College Student´s last blog ..Savings Rate =-.
The Financial Savvy College Student:
Unfortunately most people don’t realize the added risk withdrawals open them up to. You can never prepare for something you don’t know about.
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