In response to my noting the collective $1 trillion hole for the state pension funds a reader asked “Why does a return of 6-8% seem OK for a pension portfolio, while 4% is the expected return for a personal portfolio?”
There are a few things here to address and perhaps clear up. First thing is that the reader might be apples and oranging a couple of numbers. Generically speaking a portfolio might average 8% per year over some long period of time which is different than a safe withdrawal rate. The issue with the state pensions, or any pensions really, is that they have liabilities that must be paid every year in the form of pensioner benefits. If a worker is entitled to $1773 per month then the fund has to pay him that amount every month, period.
In any 10 or 20 year period 8% might be the average annual number like maybe in the 1990s but in another time period like decade just ended it might less, even negative. The problem created by a negative decade is obvious, the fund pays out the benefits as the value of the fund shrinks (or maybe not depending on any funding but you get the idea).
Maybe not, but it seems like the last two decades were very extreme; one very good and one very bad but whether that is true or not one thing that is true is that no matter what the average per year it will rarely hit that average number in a given year. One look at a Stock Trader’s Almanac will tell you that.
If a newly retired individual has a $1 million portfolio and plans to take out $55,000 he will be just fine that first year if the stock market goes up 10% and his portfolio goes up 8%. In a simplified world after that type of year he will have $1,025,000. If in his second year the market is up 2%, the investor matches it and takes the same $55,000 he will finish the second year with $990,500. So two up years in the market to start but he has already below where he started.
Lets say that the third year turns out to be 2008 but he does a great job avoiding the full brunt and he only goes down 15% in a down 38% world but thinks he can take out the same $55,000. He would be ending that third year with $786,925 and his $55,000 is now a 7% withdrawal rate Being down 15% is a very generous assumption.
If the third year was not 2008 and the market went up 8% and our investor was up 10% the portfolio would be $1,034,550. Whether the third year is 2008 or not is a matter of luck. Whether an investor ever encounters a 2008 in their retirement is a matter of luck. Clearly this investor starting with a 5.5% withdrawal rate is subject to the vagaries of the market but he is just one person and there are not that many moving parts.
Running a pension has far more moving parts and less flexibility on payouts and investment policies but faces the same varies of the market. Additionally there are pensioners coming and going all the time making it more complicated. While I’m not going to crunch the numbers for this post it has been noted in many places that often a disproportionate amount of the total appreciation in a bull cycle comes from just one year (think about 2003’s contribution to the bull ended in October 2007). This means that the typical year might have returns that are less than the average but the state pensions still have the same obligations no matter what.
It is with this sort of thought process as a backdrop why although a portfolio might, I say might, average 8% over some period of time it makes sense to make the withdrawal rate as small as possible keeping in mind a reasonable income need and survivability of the portfolio. I believe most studies find an optimal amount being 4.2% which many people tend to round down to 4.0%.
From there it gets cloudier; 4% and then adjust for inflation every year some would say. I don’t get this one. What if after ten years $1 million starting point is still $1 million but inflation works out such that the adjustments for same mean you take out $50,000?
The denial that surrounds this concept will cause an awful lot of misery I am afraid. As I mentioned during the week (albeit with different numbers) it is unlikely that someone who has accumulated $1 million has a lifestyle, even if it is modest, that only requires $3333 per month.
If you think about it there are all sorts of variables at play starting with when you retire that can either make it very easy or very difficult. This is why I believe in living modestly relative to your income and working longer or in other words creating a large margin of safety in your numbers.
One thing not mentioned above but that we have talked about many times before is expensive one off events like expensive home issues or medical events. If you can live comfortably on 4% that is quite commendable but what happens if your roof has to be replaced or you have some sort of foundation issue? Someone with a margin of safety can better navigate these sorts of things than the person who uses his margin of safety to buy a boat. Nothing against boat owners but I heard a guy (over my iPod) bitching about his boat expenses at the gym yesterday–he is underwater and needs to sell it fast.
The easiest way, IMO, to have enough money is to work on getting the overhead down. It is a lot easier to cover your nut if your nut only consists of utilities, insurances and food.