Investing for Retirement
You may face as many as four retirement investing scenarios:
- Working years when you are saving and accumulating retirement assets
- Early retirement years when you take some risk to offset distributions, expenses, and inflation
- Late retirement when you no longer have to take risk (you can't run out of money)
- Late retirement years when you continue to take risk to increase the assets in your estate (benefits your children)
All investment performance assumptions must be compatible with your tolerance for risk that changes based on increasing age and circumstances.
There are multiple investment horizons: Mid-working years, late working years, early retirement years, and late retirement years. For example, you retire at age 65. You and/or your spouse has a 75% probability of living into your 90’s. You have an investment horizon of 30 or more years the day you retire. Your assets have to produce adequate returns until you have lived past the risk of running out of money.
Sources of erosion reduce your amount of assets or the purchasing power of your assets. For example, 7% is your average performance during your early retirement years. Did you really increase your assets by 7%? No and here is why (example):
- You distributed 5% to fund your standard of living
- You paid 2% to the professionals who provided financial advice and services
- Inflation was 2% during this period. Why inflation? It reduces the purchasing power of retirement assets. If you want to protect your purchasing power, your investment performance has to offset inflation
- We assume no other expenses (admnistrative fees, transaction charges) are deducted from your accounts
Three of the most common forms of erosion add up to 9%. Your performance was 7%. Your real return was a negative 2%. This shortfall is not catastrophic if your investment horizon is ten years or less. You can always invade principal to make up the difference. This is a major problem if you have a 30-year horizon.
The higher your distribution rate, the higher your performance requirement and your exposure to risk.
Total Return Investing
If you are like most investors, you avoid invading principal to fund your standard of living during retirement. Spent principal no longer produces future income. Spending principal is a major problem if it occurs during your early retirement years or for a prolonged period of time. For example, the U.S. has had extremely low interest rates for several years. You already know what happens if you earn 2% in interest and you distribute 5% to cover your living expenses.
There is an easy solution. Each year you distribute a percentage of the current market value of your assets. There is no difference if you distribute income or market value. A dollar is a dollar. As long as your rate of return exceeds your distribution rate you have not invaded principal. For example, you start the year with $1,000,000 dollars. Your 7% rate of return is 2% income and 5% appreciation. You distribute 5% to fund your standard of living. At the end the year you have $1,020,000. You did not invade principal. This calculation is before the deduction of any investment expenses.
Down years are a major source of trauma for most retirees. They are taking distributions during years when the securities markets are producing negative rates of return. Using the above example, you started the year with $1,000,000. You distributed 5% to fund your lifestyle and the markets were down 5%. You end the year with $900,000. The decline in the value of your assets is traumatic, but should be expected. Markets will always go up and down. Fortunately they go up more than they go down.