John and Eileen, recently retired, sat at the kitchen table reading a newspaper. They had met with me a couple of months earlier. Per the plan we had put together, they started taking out the gains their retirement investment made.
John looked up from his newspaper and said, “Dave told us that he is sending us 5 percent of the portfolio value every year. Since we have $800,000 in savings, that’s $3,300 a month from the account. I’m so glad we met with him. Now we have a financial plan. The only money that we are spending is the money that the investments are making. Since we are only spending the earnings, it’s a sustainable long-term plan.”
“I agree!” said Eileen happily. “It is so nice to have permission to spend some of our savings.”
A few months passed by and the markets showed consistent growth. Not only were John and Eileen getting $3,300 a month, but the account was actually growing above and beyond the original value.
“This is great!” exclaimed Eileen. “I never considered this money would grow during our retired years. Dave was completely right. It is ok to start enjoying our hard-earned money.”
For a couple of years, the plan worked perfectly. The markets were performing well. Getting that check each month with the value continuing to rise almost seemed magical.
Then, the markets started faltering. John and Eileen began to see their portfolio value erode away.
“This is crazy,” Eileen said, “We can’t be spending money with the economy so uncertain. It’s irresponsible to take money out of an investment account when the value is down. Isn’t that ‘buying high and selling low?’”
“You’re right,” John said. “Shouldn’t we just stop the monthly distribution check? I would rather die than run out of money in retirement!”
“Hold on there, John. Getting upset and agitated isn’t going to help anything. Let’s call Dave and see what he says” Eileen said.
And this is what I tell them, and every retiree who calls me with this worry when the market has a little (or big) wobble.
This story is common to retirees. Usually, the fear and uncertainty you feel are based on a lack of historical perspective.
The first common misunderstanding is the total focus on securities/stocks. You don’t have all of your money in stocks. Diversified portfolios contain both stocks and bonds. Remember, generally speaking, whenever stocks go down bonds go up.
In 2008, during the housing crisis, the stock market went down by -36.55%. A portfolio of U.S. Treasury Bonds increased by +20.1%.
Whenever the stock market is faltering, you simply take your monthly distributions from the bond portion of the portfolio. Having a balanced and diversified portfolio gives you the flexibility to take money from what is performing well at the time.
This is a powerful tool against stock market cycles. For those of you who are clients of mine, while you probably don’t realize it, I’m sending you money from assets that are performing well. If the stock market is way down, you are getting your distribution check from the bond side of the portfolio.
The 5% you get each year is an average.
Let’s say you retired in 2005 and put $100,000 into the stock market. Three years into your retirement, you witnessed your account value plummet due to the housing bubble. But you still faithfully spent your 5% income check each month.
Ten years later in 2015, your account, after taking your 5% per year, would have still grown to $121,539. Just imagine if you spent those ten years completely ignoring your investments. It would have saved you a ton of heartburn.
If you had actually obsessively followed the markets, in 2009 your account would have temporarily dropped to $80,000. It is essential to understand that markets go up and down but overall they go up. Taking out 5% has worked every time for 90 years.
Let’s get really crazy. What happened if you invested $100,000 in 1935? Over the next ten years, World War II would come and go. Taking 5% of your portfolio each year would have been crazy, right? We were at war for goodness sake.
If you started with $100,000 in 1935 and withdrew $5,000 per year for ten years your remaining balance would have been in 1945 <drum roll please> $164,523.
Maybe this is a more simple way to explain this strategy. If between now and the end of your life, a balanced and diversified portfolio of stocks and bonds does not average 5% it would be the first time in economic history.
That’s true for our fictional friends John and Eileen, and it’s true for you too.
Don’t feel strange when you are spending money from an account that is going down in value. It is all part of the plan. There will be good times and there will be bad times. A well-designed portfolio and plan will allow you to spend the appropriate amount without fear.