How Long Will My Money Last?

By Bert Whitehead, MBA, JD

Dear Bert: I have read in various publications that the safe withdrawal rate from an investment portfolio during retirement is around 4% if you want your money to last. Could you please comment?
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While I recognize that the 4% withdrawal rate has become the standard wisdom in financial planning, I respectfully disagree. Keep in mind that most financial planners are actually investment managers, and so minimizing the withdrawal rate keeps more assets under management for them, and correspondingly higher fees.

It seems to me that a withdrawal rate must take into account the after-tax return to the client. This is highly individualized, so I don't think you can know this unless you are intimately knowledgeable about the client's tax situation. It also focuses attention on the actual tax efficiency of the portfolio. Because Functional Asset Allocation is very tax efficient, I am able to keep almost all my clients with under $3 million in their investment portfolio in a 15% marginal tax bracket. This obviously impacts their appropriate withdrawal rate.

Most financial planners figure that a balanced portfolio in retirement with 60% interest earning and 40% equities will earn ~7% over a 15-20 year period. This is historically true, and is the number I use. But then they assume an 'inflation rate' of 3% and in one way or another come to the 4% withdrawal number.

I disagree that the inflation rate is the driver in retirement. While inflation may occur in general, the overall rate has little relevance to the actual rate an individual client experiences. The CPI (Consumer Price Index) is heavily weighted by education, housing, and medical costs -- none of which are significant to most retired people (especially with health insurance which most of my clients have, even absent 'universal coverage'). CPI may be meaningful to individuals who live at a subsistence level, but most people who have a financial advisor are affluent to some degree. Just ask yourself: "When gas went to $4.00 a gallon, did that affect my living standard?"

The driver for most clients is not cost-of-living, but their "standard-of-living." During accumulation stages a client's standard-of-living generally increases at a higher rate than inflation, usually in tandem with increases in their earned income. So using CPI through the accumulation period grossly underestimates the amount a client actually spends. Upon retirement many financial planners say that clients only need 80% of their pre-retirement spending. I find that, at the beginning of retirement, clients need 100% of their pre-retirement spending.

Retirement spending normally remains flat for the first 10-20 years of retirement, as the standard-of-living stabilizes. It is critical that planners monitor client spending during the first few years of retirement. If standard-of-living increases at the same rate as when they were working, they will certainly end up living beyond their means. However, there is a selection bias I've noted with financial planning clients. They tend to be savers rather than spenders. Most often I find that a client needs permission to spend because they are so accustomed to being frugal and are afraid that they will run out of money during retirement.

Interestingly, the actual expenses needed to support a client’s standard of living starts dropping around their late 70's and early 80's. They have 'been there, done that, have the T-shirt.' They don't need to buy new cars, or to keep up with fashion demands. If we exclude gifts to charities and children, the amount they need decreases year by year, regardless of what the CPI does or how their portfolio performs. Recent studies published in the Journal of Financial Planning have corroborated this phenomenon.

Two other points about estimating withdrawal rates…

Many financial planners use software that depicts an inflated future as a single estimated percentage increase of past expenses. As you well know, I consider financial planning to be a process, not an event. Clients are generally very capable at adjusting their behavior. If there is a lean year in the stock market, they put off an expense until times get better. The software projections don’t show how smart clients can be!

Another point is that investment managers define their value as “return on investment.” However, clients tend to view supporting their lifestyle in terms of liquidity, or simply “will I have the money?”

As you know, our approach (Functional Asset Allocation) uses 15 year bond ladders with US Treasuries to assure that a client's pension, social security, and cash flow from the bond ladder is sufficient to meet their living expenses, including income taxes. This approach requires that we manage a client’s living expenses, preferably for 5+ years before they retire so we can determine the amount needed from the bond ladder. Note that Treasuries are not included in a portfolio to generate yield, but rather to provide guaranteed cash flow. "Safety Trumps Yield" is our mantra for this portion of the portfolio. We stress liquidity, not performance.

The 15-year span enables the stock market to fully cycle, so that the bond ladder can be replenished during prosperous years. It gives clients assurance that they will not have to change their life style for 15 years, so they don't fret over stock market down cycles and resist capitulating during severe market drops. Even over the past 'lost decade' we were able to rebuild client's bond ladders during the up years of the market cycle, e.g. 2003-2004 and 2009.

Finally, we also factor in savings of 10% of a client's income each year, which is reinvested in their portfolio. Obviously if clients save 10% each year (which they are accustomed to during their working years), they will by definition continue living within their means. This eliminates the need to estimate their life expectancy and makes Monte Carlo theory, which calculates the probability of future investment returns, largely irrelevant because they will never run out of money.

In summary, 'withdrawal rates' that are based on combating inflation are much too simplistic to determine a client's real annual cash flow requirements. The driver for income in retirement is not a ‘withdrawal rate‘ that depends on the Consumer Price Index, but rather changes in expenses needed to support their personal standard-of-living.

The Gold Frenzy

By Bert Whitehead, M.B.A., J.D.

These blogs are intermittent because I only write them when a topic is raised by a client. Clients have recently been asking about Gold, and it’s been in the news since the value has increased to over $1,200/ounce. This is an actual response to a recent client inquiry (edited as appropriate).

Dear Bert,

Please give me your thoughts on reducing the ladder to a more frugal level, and buying gold with the difference. If a person were to buy, say $1mm in gold, would you think storing it in say 5 different safe deposit boxes would make sense?

Hi Joe,

Of course it is your money, so I can advise on whatever you decide to do. I also know that you realize that you tend to be impulsive, and have a knee-jerk reaction to market volatility. This is the reason, I assume, why you emailed me – and I am honored that you do respect my opinion. Now I’ll tell you why I think putting that much money in gold would be a stupid thing to do…

As an investment, gold never has much glitter. It isn’t really an investment, because it can’t be capitalized for growth like bonds or productive equity assets in your portfolio– any profit is based on speculation because gold doesn’t earn anything. Especially in recent years, it has been very volatile because you can now buy ETFs (exchange traded funds), which actually hold gold. As a result, speculators have been alternately dumping money in and pulling it out in sudden unpredictable moves, since they don’t have to take possession of the gold itself.

As an inflation hedge, gold has a terrible record. From 1980-2000, gold prices were essentially flat. Yet, inflation was up 3.7% per year, cutting the value of the dollar in half during that period. This is because we are now experiencing world-wide inflation. Gold can hedge the dollar, but only in relation to other currencies. As we continue growing into a worldwide economy, the dollar moves much more in synch with other currencies, and gold’s value during inflationary times doesn’t protect against worldwide inflation.

As a deflation hedge, selling Treasury bonds to buy gold would leave you extremely vulnerable to deflation, which is the primary global concern right now. If the US dollar were to drop so that it was virtually worthless, you might think that gold would become the substitute currency. The problem is that anarchy would likely erupt, and guns trump gold. So you should plan on having guns and ammo, because you wouldn’t be able to count on the government to protect you.

You could move to another country, and this is a reason why you might consider holding gold. You could take your gold and run if you or your family became vulnerable to adverse governmental action. Your accounts would be frozen, and the only wealth you could transfer with you to someplace else would be your gold. Many people who distrust the government expect that guns would be outlawed, so in a severe social/economic shift you could at least have transferable wealth (assuming there was a country left which wasn’t in anarchy). This situation would likely be endogenous, where one was accused of a crime, or the IRS decided to pick on you and come after all your assets.

There are practical obstacles: Many of my clients, and that includes me, feel more secure having some wealth that is not dependent on the benevolence of our government and their management of the economy. But there are limits = $1,000,000 in gold would weigh over 50 lbs.! That would be a problem to lug across the border!

The US dollar is the world’s reserve currency, which has a unique status and advantage. No other currency (euro, Yuan, franc, pound, etc.) carries enough respect to challenge the dollar…and none of them have enough depth to support world commerce. So where does the smart money run when the world economy gets dicey? The Arabs, Swiss, Chinese, etc. all buy Treasuries, which is why your bond ladder’s current value has been rising so quickly in recent weeks!

Basically, Joe, you already hold the best investment you can have in these fragile times. To hedge inflation, which I reckon we will be worrying about in 6-12 months, think about making sure you have some super 4.75% 30 year fixed mortgages!!

I hope this is helpful.

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY., as well as the blog editing by Susan Stanley