The demographic of retiring baby boomers has prompted every financial institution to set forth their secret sauce for maximizing retirement income. Meanwhile, some scholarly approaches have appeared in financial journals.
The AAII Journal published by the American Association of Individual Investors summarizes three approaches. As far as it goes, the methodology holds up to scrutiny, but fails to illustrate the more aggressive techniques that retirees need to adopt. Who in their right mind would choose a plan that offers a 22 percent chance of running out of money in 35 years? Anyone adopting that plan could be peering into a financial abyss just about the time they were entering a nursing home.
The AAII models start with the assumption that the money is invested in a typical 50/50 mix of stocks and bonds. Two of the three assume that it is OK to eat into principal and run out of money as long as the probability is low. The starting extraction rate (or retirement income from the nest egg) is 4 percent per year for all three models.
Where the three models differ is based on what determines the change in the starting dollar amount.
The first model increases the income rate based upon the rate of inflation. The problem with this approach is that inflation could be much higher than any gains in the stock market (remember "stagflation" back in the '70s), so if income extracted from the account is rising faster than capital appreciation, your goose could be cooked. With this model, there is a 22 percent chance that you would be completely out of money in 35 years, based on projected economic events.
Plan B keeps the 4 percent figure constant, but the dollar amount would change as the size of the nest egg varies from year to year. The half invested in stocks would be expected to rise over any rolling 10-year period, but 4 percent from the entire account taken as income each year might not be enough to pay bills in a world of hyperinflation. However, with this approach, there is a 100 percent chance that you will never run out of money even if it's a struggle to pay bills.
The third approach covered in the AAII Journal was one suggesting a modification of the 4 percent of account balance approach. It proposes that a floor and cap be applied to the change from year to year in the dollar amount. If the stock market rises by 20 percent, for example, the 4 percent figure only increases by a maximum of 5 percent of the previous year's income in dollars (the cap). You don't get to increase spending by the full benefit of that windfall, and you save some for a rainy day. If the market crashes, you only reduce income by 2.5 percent of what it was the previous year. This could mean eating into principal if the stock side of the portfolio dropped by 35 percent, a la 2008. Statistically, this approach has an 8 percent chance of running dry by the end of 35 years.
My problem with these strategies was that they used numbers generated by broad stock and bond indexes rather than using some creativity. As for bonds, a retiree could generate more retirement income by using bonds and bond funds that involved more risk and paid higher rates of return -- high-yield bond funds and emerging markets government bond funds come to mind, but there are many similar alternatives.
As for stocks, a retiree can choose large-cap value funds or utilities funds that churn out high dividends. The "Dogs of the Dow" (the 10 highest yield Dow Jones companies) are paying an average of about 4 percent today. Finally, the 4 percent figure you often see in all of these studies presupposes that about 1 percent is being spent on expense ratios, brokerage services, fees to advisers, and/or commissions. Anyone adopting their own buy-and-hold strategy with individual stocks or who shops for no-load mutual funds, avoids this cost and turns the former net 4 percent into what might be 5 percent.
My approach basically accomplishes what most wealthy people swear by: Live on interest and dividends and never touch the principal -- until you need it for those nursing home bills at the end of life.
Stephen J. Butler is CEO of Pension Dynamics. Contact him at 925-956-0505, ext. 228 or email@example.com.