The Retirement Equation

In life one of the most if not THE most important equation that needs to be solved is how much do I need for my retirement.  The equation is not as simple as it seems as there are numerous variables that will undermine even the most detailed analysis.  As we all know the inputs are; the size of the asset base, the annual returns on that asset base, the remaining life span of the investor and the annual expenses.  These variables change constantly and therefore make it even more complex to determine the amount needed but financial planners like to assure investors that they are covered when often times they are not.  I thought it would be useful to open pandora's box to show you how hard it is to determine the appropriate number and to make you consider in far more detail the inputs and the outputs before you make too bold a step into the world of retirement.

The first variable is the size of the portfolio.  On this front it is always better to have more than not enough.  To me the size of the portfolio needs to be of a size that will be resilient regardless of the market gyrations.  There is no doubt that should you live another 20 years, the market will throw a spanner into your engine of returns and the draw down will destroy the supposed smooth line of returns that you are expecting.  Just take the current market for example.  For those that have followed this blog for some time you will know that I believe the market to be manipulated and over priced but the alternatives are producing such low rate of return that you are almost forced to take on too much risk to produce a meaningful number.  This means that even now (or should I say especially now) the returns to your portfolio (if you want low risk which most retirees do) are too low to support any "normal" expenditure.  One way around this is to invest outside the box but the other way is to have a portfolio that is so big that it does not matter.

Well as this is not a solution for most of us the next alternative is to delay your retirement as every year that you work not only adds to the size of the portfolio but also reduces the amount of time that the portfolio has to support you by one year.  The less time that the portfolio is required to provide support the lower the size of the nest egg and/or the return requirement both of which are a huge benefit to your portfolio and its ability to achieve its goal.

The next thing to consider is the average annual return.  As I have mentioned, achieving a meaningfully positive real rate of return (that is the portfolio return less inflation) is virtually impossible at present unless you take on far too much risk.  Risk here is defined as the probability that your portfolio will suffer a large draw down from which it can never recover.  Most people that I talk to seem to be in this camp as they are not considering the alternatives for the simple reason that their investment advisor is not able to sell them the alternative investments.  This is a flaw in our investment system; the people that need the alternatives the most are "protected" from them so that they are not exposed to losses.  In the meantime they are lead to the slaughter like lemmings but those are the rules and I pity those that are forced to follow them.

The next point regarding returns is that they will change year in and year out.  The idea of a smooth line is almost impossible to achieve so the portfolio has to be able to sustain a draw down and recover.  This is why the average planner suggests that retirees only withdraw 4% of their portfolio each year.  This small amount protects the portfolio but often reduces the amount that the retiree can withdrawal to such a small amount that it does not benefit the retiree at all.  Assume you retire on $500,000 and you can withdraw 4% a year, that is only $20,000 a year or roughly $1,800 a month.  While not a small amount it is not big enough to support most active lifestyles and most retirees do not even have half this amount saved!

Looking at life expectancy tables shows that the older you are the longer you have to live.  So for example at 50 the tables show that you have roughly 35 years to left live but if you are 85 the tables do not show zero years to live but show roughly 10 years left.  The probability that you will live longer is higher the older you get and therefore to plan your retirement requires a constant adjustment to your life expectancy all the while your portfolio size is finite (other than the returns on it).

The final input is the monthly expenses.  While we all know that 95% of our medical expenses are incurred in the last 5 years of life what most planners do not factor is that spending habits change with the size of the portfolio.  People are not going to blindly spend the same amount of money each year particularly if the portfolio size diminishes rapidly due to unforeseen market forces.  People will adjust their spending down as the fear of outliving their income will quickly place a crimp on the spending.  The main issue here is that the catch all, annuities, are not factoring a lot of these inputs as there simply has not been enough time (and here I mean enough years to have past to produce data) to capture the data required to factor in all of these inputs with a sufficient level of understanding to underwrite the majority of the risks.  Not that I expect the annuity world to blow up but it is something to consider when you are told that you are covered because you have an annuity.

So with all of this said it is really clear why you need to constantly review your investment portfolio as there are no constants even if your planner assures you that they have it covered!