About 25 years ago I gave educational seminars for our local YMCA on Financial Planning. They were three night, 2 ½ hour classes, and were pretty in depth. I believe we charged $40 a couple back then. Most of what we taught then still holds up today, but some things have changed. Among them: How we determine a withdrawal rate, or the amount of money as a percentage you can safely take from your investments and not run out of money. This is a crucial piece of information and is often misunderstood. Allow me to illustrate:
Back then it was common practice to assume that if your investments earned 10% per year, you could take out 8% per year, allow for inflation increases to your withdrawals, and not run out of money. The logic was simple – you are earning more than you’re taking. That logic was also flawed, and the financial industry had to make some adjustments to their thinking.
The flaw was in assuming that the AVERAGE rate would be earned every year. There was another flaw that some still haven’t addressed. Namely that you can still expect to earn 10% per year. A well-known ‘Get out of debt’ radio host still uses this flawed assumption of 10% per year. Did you know that since January 2000 the major market indexes have returned less than 5% per year? AND you lost 50% or more twice along the way. But I digress. Let’s get back to the withdrawal rate problem.
Assuming an average rate of return ignores something called the ‘Sequence of Returns’. Average rates of return ignore this principle, and it can be devastating to someone in retirement. Here’s an example:
Investment ‘A’ has annual returns of +20%; +10%; -15%; +30%; -50%; +10%. The AVERAGE annual return of this sequence is 16.7%. WOW! Some would assume that I could safely take 10% per year, right? But what if the sequence were reversed? I would still average 16.7%. And this is fine when you are GROWING your account. In the accumulation stage the sequence doesn’t matter. But what happens when you are TAKING your money out?
Using the annual return numbers above, let’s assume you have $100,000 and your advisor tells you that because your investment has averaged 16.7% per year, you can safely take out 12%, or $12,000 per year. I am not going to use any inflation adjustments – let’s try to keep this simple. Using the FIRST sequence, the ending balance of our account would be $24,527. WHAT?!?! You earned over 16% on average, and only took 12%. Shouldn’t your balance be HIGHER than the initial $100,000? It gets worse. Reverse the sequence of returns – remember, that still gives you the same 16.7% average return – and you actually run a negative balance by the end of the 6th year….. The SEQUENCE of the returns that give you that overall average have a major impact on your financial success in retirement.
There ARE ways to calculate a sustainable withdrawal rate, and to take money out while reducing the risk of your account going to zero. I’ll cover some of them in the next article.
In the meantime, if you have any questions you’d like answered please email them to CJohnson@GuardianPlanners.com. Put ‘TL News’ in the subject line.
Any examples given are hypothetical only and are not intended to reflect the actual performance of any investment.
Chuck Johnson and his wife Beth have lived in the DuBois area most of their lives and have lived at Treasure Lake since 2009. Chuck holds the ChFC and CASL designations from the American College and is the owner and principle advisor of Guardian Planners, working in the financial services industry since 1988.
Charles W. Johnson is a registered with and securities are offered through Kovack Securities, Inc. Member FINRA / SIPC. 6451 N. Federal Hwy., Ste. 1201, Ft. Lauderdale, FL 33308 Tel: (954) 782-4771. Advisory services offered through Kovack Advisors Inc. Guardian Planners is Not Affiliated with Kovack Securities, Inc./Kovack Advisors, Inc.