Today I'm going to write my second installment in a series about generating an income for life from your nest egg. The first installment was all about generating income from bonds. That posts brings up two huge risk factors to creating a life long income: 1) inflation and 2) volatility.
Inflation is the term for the upward trend in prices over time. Do you remember when gas was a quarter? I don't because I'm too young, but I do remember when it was less than one dollar. I miss the days of $0.99 gas, but inflation has left that price in the dust. There was also a time (so I'm told) that a hamburger, fries, and a coke was only a quarter too. In other words, prices on everything increase over time.
The second risk factor for generating lifetime income is volatility. In layman's terms, volatility is unpredictability or randomness. From one day to the next the stock market can be up, down, or flat and there is no way to accurately and consistently predict which it will be. Sure the broad trend is for markets to go up, but that does not hold for short time frames. The implication of this randomness is that over short periods of time (even years) the market can return significantly less (or significantly more) than the often quoted average.
If all of this is unclear I'll use a few examples to try and help. My first example is a man Jack who retires with a tidy $1,000,000 today. He knows that a conservative mix of stocks and bonds has historically returned 6.0% per year. He then decides to withdraw at the start of each year 6% (or $60,000) on which to live. If we first consider inflation, after 10 years the $60,000 withdraw will now be worth only $45,000. Jack has seen the value of his money drop by 25% in only 10 years! If this process continues for 10 more years Jack will only be able to buy $33,000 worth of goods with his original withdraw. The value and purchasing power of his retirement savings will continue to drop every year.
Now, lets again consider Jack and his $1,000,000 nest egg. We will still assume his mix of stocks and bonds returns an annualized 6%, but now we see that in any given year he can have volatility of 9%. That means each year his returns will be anywhere from -3% to 15%. If Jack starts out with a string of good years and the size of his nest egg will initially go up; Great! he is now in a position where he can withstand an occasional bad year and still maintain his income. However, if Jack starts off with a few bad years (or even mediocre years) near the beginning his nest egg can shrink quickly. Lets say the first year Jack's return is 5%, then 0%, then 9%, and then 10%. The average of these four returns is 6% which would seem to point to a withdraw of $60,000 per year. However, look at what actually happens:
| Nest Egg | Return | Income | |
| Start | $1,000,000 | ||
| Year One | $987,000 | 5.00% | $60,000 |
| Year Two | $927,000 | 0.00% | $60,000 |
| Year Three | $945,030 | 9.00% | $60,000 |
| Year Four | $973,533 | 10.00% | $60,000 |
I recently came across a great resource to help understand how the effects of inflation and volatility will affect your probability of running out of money during retirement. This tool is called FIREcalc. It is a free calculator that uses the real historical data from the stock market to determine the likelihood of success for obtaining retirement income for life. The way it works is to take an initial assumption about the size of your nest egg, the amount of income you intend to withdraw each year, and how long you need the money to last. Next real historical data from the market is used to project what would happen if you had retired in each year from 1929 to the present. Each of these hypothetical retirements is calculated to determine if the money would run out before the assumed time period. You can see if your strategy would have made it through the Great Depression and the 2000 Tech Bubble and still be able to meet your income needs.
When the previous example about Jack and his $1,000,000 portfolio is plugged into FIREcalc it reveals some scary results. With a $60,000 annual withdraw and a 23 year life expectancy (such as age 62 to 85) the result is a 64.9% success rate out of 114 trials. Simply put, in 40 of the trials Jack ran out of money before he hit 85. The tool is based on real life data, and it clearly shows how volatility and inflation are able to sink a seemingly robust retirement portfolio. If you lower the annual withdraw to $40,000 or 4% of the total, the success rate jumps to 100%. In other words, in the entire history of the market you would not have gone broke during your retirement if you keep withdraws down to 4% per year.
I spent some time running dozens of scenarios since I discovered this great tool and I recommend everyone take some time and do the same. You can learn a lot about the your realistic chances for retiring with income for life. For another take on this topic that comes to very similar conclusions using a different approach (a statistical model called Monte Carlo analysis) check out this article called The Retirement Calculator From Hell. Also be sure to check back with Aspire 2 Wealth to follow my path to wealth and read more articles about personal finance.
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