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Weekly Insight |
July
23, 2004
IN THIS ISSUE:
Let's review last week's first installment on accumulating funds for retirement and go a step further by asking the question, "How much is enough?" The series will continue in two more parts, "Maximizing income and growth in retirement" and "Some estate tips".
Retirement: How Much is Enough?In the first installment, we asserted that a diversified portfolio of common stocks is the best way to build a retirement nest egg over a thirty-year period. Thirty years appears to approximate a complete cycle. Quite consistently, thirty-year periods are divided into three parts: a down decade, an up decade and a mediocre decade. Of course, down, mediocre and up have different values as you compare the decades. The 80's and 90's were, by far the best two decades in the last century. The 70's were essentially flat, with lots of hills and valleys in the interim. The 40's were not very good, the 50's were superb and the 60's were pretty good until the Vietnam War and increased U.S. uncompetitiveness made it into a pretty mediocre decade. There is always some fundamental reason to continue the pattern, but the pattern continues. One up, one down and one essentially sideways to moderately good.
Asking, "Where are we now?" is a fair question. The answer is, "We never know, with certainty." We can propose that this decade will have a lot of mopping up from the excesses of the 90's and, arguably, the early 00's when interest rates were held to historic lows for years. It is also logical and pattern following that the decade of the 00's will be generally poor.
That said, a look at foreign markets tells a different story. The 70's were quite good for Japan, as it was coming into ascendancy that would peak in 1989. That said, markets are better coordinated in this era of global trade and interdependence, so the old comparisons may not have as much significance as they once did. Still, the patterns are clear; this decade will see stocks and maybe bonds swimming against the current.
The moving force of consequence
this decade is the modernization of China, India and other "emerging"
markets. So this decade may not be at all bad, provided that one is more adventurous
and opportunistic than one needed to be in the 90's.
On to the central question, "How much is enough?" We have a simple
formula; annual spending must be less than the three year average account
growth by 3% and always cut in half whenever your account falls 10% or more
in a year. For example, suppose your three-year annual growth rate is 8%.
Subtracting 3% (average inflation for 100 years), you arrive at an allowable
withdrawal rate of 5%. Suppose, though, your account drops from $1 million
to $900,000 over the space of a year. If you took out 5% in the prior year,
you can only withdraw 2-1/2% this year.
But, you say, how much is enough? How much do I have to save to make my account
large enough?
The sad fact is that you will never receive an exact answer to either of these questions, for a variety of reasons. Primarily, no one knows the future, including your life span. Secondly, no one knows the lifestyle to which you will be accustomed in the period just prior to your retirement. Even more interesting, no one knows whether you will retire; you may continue to work until you drop because you love it.
We can approximate a few things,
though. If you look at a 5% annual withdrawal (defensible under lots of scenarios),
an account size of $1,000,000 will gross you $50,000 a year for life, not
eroded by inflation provided that the long term average of 3% persists and
that you average at least 8% a year total return on your invested money. However,
to be more accurate, you must express that million bucks in future dollars,
as you will be spending them. Suppose you assume 3% inflation, your account
will halve in purchasing power terms in 24 years. Thus, using this simple
example, you need $2,000,000 in tomorrow's dollars to retire with the equivalent
of $1,000,000 in today's dollars.
Here's the rub. The figures we used above are averages and approximations.
We could experience deflation, not inflation. Any number of things can happen.
There is a huge problem when we use a deterministic model (static values)
to approximate future values. Things might work out on average in 100 years,
but the 20 years you are interested in may have vastly different characteristics.
For example, inflation was nonexistent in the 30's and most of the 40's due
to depression and World War.
Is there a better way? The answer is yes - and no. You can get some pretty
sophisticated models these days which employ such techniques as "Monte
Carlo", "mean variance optimization" and even "Rolling
trailing period analysis". All of these use sophisticated probabilistic
calculations to give you any degree of probability your account will be X
in a specified period number of years. But even these wonderful tools - nectar
to the seeker of a figure they can call solid - spew an answer heavily dependent
on assumptions.
Thus, while you may have a warm security blanket of calculations, you have no real assurance that you will outlive your account or, phrased another way, your account will not fall to zero before your blood pressure does. So what's a person to do?
We urge people to give extra weight
to funding retirement accounts when young, preferably at birth. Unfortunately,
babies don't work and young workers have lots of other stuff to think about.
Okay, parents - here's where you can excel. Start an account - an Education
IRA or 529 plan - for your child or grandchild at birth or thereabouts. Contribute
to it until age 18. Then fund a Roth IRA for another, say 15 years until your
child is old enough to appreciate retirement savings. Then they are on their
own. Or, even better, offer to match their account contributions as an employer
would an employee. In this way, both education and retirement needs are given
a huge boost due to the "time value of money". For reference, the
time value of money concept posits that investments compound over time. Thus,
a $1,000 contribution which earns $100 will have a base of $1,100 in the following
year and so on. Compounding is very powerful, but works best when an account
can be held to grow for more than 20 years.
Any way you look at it, your early contributions have the most power because
they are compounded the most.
As you begin a plan, ratchet your assumptions down from what you might consider the norm. Then check your progress every five years. More frequently is usually not necessary. You may adjust your assumptions as you go, but don't fall prey to the temptation to ratchet up assumptions for a new period based on great returns for the prior period. If nothing else, keep them the same and consider the better than average performance a gift.
The worst-case scenario, if you are diligent, will be to give yourself a free pass for the last few years prior to retirement or, even better, you could retire early or do anything else with your "free money". Interestingly, that's the best-case scenario, too.
One more thing - you may access your retirement account penalty-free in the event of disability. Certain accounts may also receive loans, but remember that money borrowed from a plan removes it from investment.
In sum, there is no guaranteed
way to be sure you do not outlive your assets. It's best to save enough to
give you a buffer. Life expectancies are rising, and may rise even further
before you are fully transitioned into your new existence.
Feel free to contact us to help you with planning. We want your total investing
and withdrawal experience to be happy and rewarding. Next week we'll consider
the issue of how to manage the money you have accumulated once you retire.
Until then, hasta...
Jim
Feel free to share this newsletter with others. Those wishing to receive future issues may contact us by email at jim.pursley@gaiacapital.com. Gaia Capital Management, Inc. is a Registered Investment Advisor, managing accounts for individuals, families, businesses and institutions. We welcome your inquiry about our services.
Jim
Pursley
Gaia Capital Management, Inc.
The opinions contained in this report represent the author's current knowledge and are based on sources known to him at the time of writing. Such opinions are subject to change at any time and are presented for educational value. Any other use, such as investment solicitation, is inappropriate and absolutely unintended by the author. Readers must evaluate information herein presented according to personal situations, goals and expected future needs.