March 2000 Newsletter

Living Off Your Portfolio

Many people come to us asking, "do I have enough money to stop working and live off my portfolio?"

For example, Bill and Betty have carefully saved and invested for their retirement, and have accumulated $1.2 million in assets. They need $60,000 per year, inflation adjusted, after taxes for basic living expenses, would like to spend some additional money each year for travel, and will receive $12,000 per year in Social Security benefits. Both Bill and Betty are in good health, and would like to run the projections until age 80. They are currently age 50.

Their portfolio is invested 50% in blue chip stocks, 25% in intermediate Treasury notes and 25% in CDs and money market funds. They don't want to take a lot of risk with their money, but understand the need for equities to fight long term inflation risk on their spending.

A typical retirement projection would put in all of Bill and Betty's facts and numbers on income and spending, and use average returns for the portfolio and an inflation rate. Since no one can actually forecast the future, programs use either an historical basis for these numbers, or an educated prediction.
We could look back over the last

30 years and find that Bill and Betty's portfolio mix had an average return of 10.7% and inflation averaged 5.4% (1968 thru 1997). If we put those numbers into the program, their future looks like this:

Average Results

This makes Bill and Betty feel very confident about their future: not only are they not going to run out of money, but they are actually building their portfolio over time.

But is this really true? Using averages hides a lot of year-to-year and month-to-month risk in portfolios. Let's rerun the numbers using the actual returns from the last 30 years:

Historical Returns

Instead of building their assets over 30 years, Bill and Betty have consumed their
portfolio in 20 years!

What explains this difference? Using the last 30 years, Bill and Betty's portfolio actually would have experienced annual returns from a loss of 12.7% (bear market of 1973-74) to a gain of 24.7%. Their cost of living, as measured by CPI, ranged from 1.5% to 13.3%. Since they need to take out their annual spending each year no matter what their rate of return or inflation, in the "bad" years, they experience the reverse of dollar cost averaging: selling off more shares in order to net the same amount of money. If this happens early in your retirement years, the portfolio can fall behind and never recover.

This phenomenon, called "distribution of returns" or "variation of returns," is what's behind the conventional advice given to retirees: reduce the level of risk or volatility in your portfolio, and consider moving more money into bonds, which are more stable than stocks. Another solution to the problem is to plan for a smaller withdrawal rate from your portfolio.

Most people look at their pot of money and say, "I've got $500,000. I can invest that to earn 8%. That means I can take out $40,000 a year and still not be spending any principal, right?" Unfortunately, it is not that simple; it works in the first year, but not over the long term. You want that $40,000 spending to go up each year with your inflation rate, and you want to be able to withdraw money whether the stock market is up or down. The problem becomes compounded with people retiring earlier and/or living longer, so there are more years that the portfolio has to last.

To allow for the "real world" fluctuations in returns, a more prudent withdrawal rate might be in the range of 3.5% to 5.0% per year, depending on how much of your portfolio is in the stock market and how many years you want it to last. These withdrawal rates also recognize the potential for another bear market in stocks.

For example, if you don't want to have more than 50% of your portfolio invested in stocks during a 25- year retirement, you might use a 4% withdrawal rate. Thus, if you want $40,000 per year to live on, your portfolio needs to be $1 million instead of $500,000 (or if your portfolio is $500,000, your withdrawal number should be $20,000 instead of $40,000). And remember that your withdrawal rate is a before-taxnumber, so don't forget to plan for income taxes.

Of course, it is still not a guarantee, but attempts to provide a more realistic "rule of thumb."

Continuing Education

All three Portland planners (Mary Christensen, Steve Hewitt and Deborah Thomas) attended two days of continuing education classes in January, sponsored by the Financial Planning Association of Oregon and Southwest Washington. Deborah also went to the annual Estate Planning Council seminar, and will be attending the FPA Master's Retreat in Phoenix in April. Tax law changes, new securities regulations, estate planning strategies and business management issues keep us busy trying to improve our service to our clients.

Saturday Investment Program

On Saturday April 1st, we will present the first "all in one" investment program for clients and friends of the firm. We are combining our three popular educational programs (Investment Basics, Portfolio Design and Investor Behavior) into one condensed version. From 10 am to 12 noon, all three planners will be presenting a different part of the program.

Please call Betsy Blank at 242-1715 to register. Space will be limited to 10 people. The building is locked on Saturdays, so we will meet you in the lobby at 9:50 am. Our regular monthly program schedule of classes is also enclosed; these include lunch.

Tax Time

Reports have gone out to all of our management and retainer clients who had sales of securities in 1999, providing tax basis information for your tax preparer. Management clients also received a letter confirming the fees you paid to Silver Oak last year, since they are deductible. If you did not receive these items, please contact Betsy or Paul for a duplicate copy.

Also, several clients have asked if we can transfer funds for their IRA contributions. The answer is no, we do not have the authority to make distributions or transfers from your Schwab accounts. You can call Schwab and ask for a transfer, or you can write a check to your IRA if you have a Schwab One account.

Tax returns and IRA deposits are due April 17 this year; but don't wait on your IRA contributions!

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