Many investors are worried that their retirement funds may not last long enough to meet their needs. Medical advancements help you live longer. But the typical retirement strategy has investors taking withdrawals that will eat up their retirement savings over time.
In a survey conducted by the Employee Benefit Research Institute (EBRI), retirement expectations differ by reality by a wide margin. Nearly two thirds of those surveyed expect to live on less than half of their job income after retirement. Actual needs are at least 70 to 80 percent1.
“People do a poor job of understanding how much they will need for a retirement that could last a long time — and many don’t understand the basics of what their expenses will be in retirement,” said Matthew Greenwald, president of Greenwald & Associates, which conducts the survey for EBRI.
This creates two problems for many retirees:
1. Retirement funds are used up much more quickly than expected (poor planning)
2. Retirees outlive their retirement funds and are forced to live out their remaining years in near-poverty, relying on Social Security alone (poor strategy)
The Flawed Retirement Strategy
The flaw isn’t in expecting to have a full retirement. The flaw is in the strategy.
There are two competing strategies to produce retirement income.
One is to withdraw a portion of the retirement funds (the principal) regularly. The other is to withdraw only cash-flow generated by investments, leaving the principal alone.
The most common, and flawed approach, is the first – to withdraw a portion of your retirement funds from the principal each month. This strategy is by far the most common reason why retirement funds may not last long enough.
We’ll take a look in more detail at why taking money from the principal is such a bad idea.
How Unexpected Events Affect Your Retirement
Here’s what happens:
Typically, a Wall Street financial advisor will recommend that you take 5% per year (or 1/20th) from your retirement funds for living expenses. With no additional income or losses, your retirement should last 20 years.
But will it?
That strategy assumes there are no fees for your retirement accounts, no inflation to reduce your buying power and no stock market crashes.
For 20 years!
We all know NONE of these assumptions are true.
Wall Street accounts have fees ranging from a low of about 1% to as high as 6.5% per year, depending on the mix of assets you own and if you have a financial advisor.
Judging by the increasing prices of most things, we also know inflation is higher than zero.
And to think that the stock market won’t crash in 20 years is just plain silly.
According to Motley Fool analyst Morgan House, the stock market drops 20% every four years and 30% every 10 years, on average2.
So during your 20 year retirement, you might expect the stock market to drop 4 or 5 times, assuming the clock starts when you retire and you don’t care about the last crash after 20 years.
Don’t Let the Crash Get You Down
If you plan to withdraw the same amount of income each year, each stock market drop will leave you short. And that means your retirement funds may not last nearly as long as you hoped.
To simplify things, let’s look at what just one 30% crash will do to shorten your retirement.
In this example, we’ll start you out with $1,440,000. Taking 5% each year comes to $72,000 or $6000 per month.
We’ll leave out the fees and inflation. In year 7 we’ll include a drop of 30% due to a market “correction.”
How long will your retirement funds last?
You will run out of money in just over 16 years.
Here’s what it looks like on a chart:
There are two things you should notice about this chart.
First the obvious one. By taking withdrawals from the principal each year, your retirement savings is getting smaller each year.
Second, at some point your savings will run out.
You Can’t Predict the Future
The biggest problem with this approach is that you cannot predict the future.
No one knows when the next stock market crash will occur or how much it will drop. Or even how it will affect other investments, such as money markets or bonds.
It leaves you wide open to a major financial setback. And by the time it happens, it will probably be too late to do anything about it.
Withdrawing from your principal relies on bad assumptions, like unrealistic living expenses, near-zero account fees, near-zero inflation and worst of all, no market crashes.
But the good news is that there is a much better approach. Instead of withdrawing the principal from your retirement funds, you can move into assets that pay enough in cash flow to keep your retirement going as long as you need.
Learn how to fix this problem in this article “The Magic Bullet of Investing.”