Be Wise When Projecting Retirement Income

By Stephen Kelley

We all know that markets go up and markets go down. But when you have a steady paycheck, the effect on your daily life is minimal.

In retirement, however if you are using the market to pay your monthly bills, and the market goes down, your cost of living just went up. Worse yet is when you sell off to purchase your standard living items or take your RMD or pay your taxes, or whatever it may be, those shares are gone forever. So if the market does rebound, it may very well do so without you.

We call this phenomenon "reverse dollar cost averaging." Dollar cost averaging is when you purchase the same dollar amount of shares on a regular basis. You will buy more shares when the market is down and fewer shares when it is up, but in the long run, this should work to your advantage.

There is some debate about this, but it sounds good anyway and has been gospel in the 401(k) industry for years, and has sold billions and billions in mutual funds.

The reverse, however, is not up for debate. If you have fixed costs, like energy, health care, taxes, food, mortgage, etc., you must have the money each and every month to pay those bills. If you have to sell off shares in a down market to cover them, your costs are higher and your burn rate goes up. And when they are gone, they are gone. This is why Wall Street-oriented planners will suggest you limit your spending to about 3%. (It used to be 4% until they saw that number blowing up retirement plans).

But wait a minute. Don't these Wall Street types tout a 7% or higher rate of return over time in the market? (http://www.simplestockinvesting.com/SP500-historical-real-total-returns.htm) So if I can expect 7% over time, why can't I take 7% out over time? To many people, this makes no sense.

The reason is that rate of return, while very important in accumulating wealth, becomes meaningless when you are spending your wealth. For an example, take a look at a very simple calculation: Assume the market has returns of +28%, -10, +15, +17, +1, +26, +15, +2, -12, and -38. That's a 4.4% rate of return over a 10-year period. Anyone with half a brain would figure out that if you are making 4.4% per year on an investment, and you took out just 7% a year with a 3% annual inflation adjustment, you should still have money at the end of the year, right?

In fact, starting with a $500,000 portfolio, if you line things up just as I have indicated, you will still have $306,151 at the end of the 10-year period. So that worked pretty well.

But what if you reversed the sequence? Instead of starting with +28%, start with -38%, and so on. What would be the remaining amount at the end of 10 years? Minus $27,772! That's a swing of more than $333,000 over a 10-year period!

Now let me ask, is the rate of return over that time period the same? If you add up those numbers in one sequence and divide by 10, is it the same number as if you added them up in a different sequence?

For example, is 10+5-6 divided by 3 (answer: 3) the same as -6+5+10 divided by 3? That answer should be fairly obvious, but if you don't believe me, check it out.

The key to this exercise is that when withdrawing money from your assets, the important thing isn't rate of return, it's sequence of return. You already know this. Assume you have 1,000 shares of a stock worth $100 each. If you need $5,000 from your holdings, would you rather take it when they are worth $100 a share or $50 a share? Again, the answer is obvious. If you take it at $100, you only have to sell 50 shares. If you take it at $50, you have to sell 100 shares. Then, when the market springs back, you have 50 fewer shares to spring back with it.

Let's say it goes back to $100 after taking your $5,000. So, $100 x 950 = $95,000, whereas $100 x 900 only equals $90,000, $5,000 less. This has nothing to do with your investment's rate of return; it's entirely about when that return happened and when you had to take the money.

So what is the market going to do? I don't know. Depending on whom you listen to, it's either going to keep on going up forever, or it's going to drop like a rock and stay there for years. Personally, I think either scenario is plausible, and that's what makes it so scary. We simply don't know, nor can we ever.

So why not minimize or eliminate this problem? Determine how much money you need to live. Subtract from that your known sources of predictable income, such as Social Security or pensions. Take the amount you would use to make up the difference, and invest in a guaranteed income product, such as an annuity, to provide income that you can't outlive.

Then sit back, relax with a cold one, and ride out the market's ups and downs. You will find your mental - and financial - states to be much easier to handle.

Stephen Kelley is a recognized leader in retirement income planning. Located in Nashua, NH, he services Greater Boston and the New England areas. He is author of five books, including "Tell Me When You're Going to Die and I'll Tell You How Well You Can Live," which deals with the problem that unknown lifespans create for retirement planning. It and his other books are available on Amazon.com. His radio program, The Free Money Guys, can be heard every Sunday at noon on 980 AM WCAP. He also conducts planning workshops at his New England Adult Learning Center, located in Nashua. Initial consultations are always free. You can reach Steve at 603-881-8811 or at www.FreeToRetireRadio.com.