AssetBuilder Inc, - Registered Invesment Advisor - Simple Investing Smart Future
in
Opml Feed
RSS Feed
Contact Asset BuilderCall Us Email Asset BuilderEmail Us Need Help?Need Help?
 

Registered Investment Advisor

Scott Burns' Articles -- Recent and Archived

Income Limits from Your Nest Egg

Q. It is recommended that retirees withdraw no more than 4 percent a year from their retirement nest egg. Is this in addition to any income that is generated from their funds? Bonds and CDs pay more than 4 percent. And some higher-dividend stocks pay more than 4 percent. If we are generating more than 4 percent a year in income and we only withdraw a total of 4 percent, wouldn't we be building the principal?

What am I missing? ---B.N., by email

A. The 4 percent figure is based on the value of the portfolio. The dividend and interest income that your portfolio generates is considered part of the total return. The remainder of the return comes from capital gains or losses.

Another way to look at this is that your portfolio needs a total return that is equal to your withdrawal rate plus the inflation rate--- roughly 7 percent--- if it is to generate a growing income.

Many people forget this important part of the portfolio survival studies--- that the 4 percent figure is your initial withdrawal rate. It is assumed that your withdrawal increases at the rate of inflation every year after that. Otherwise, you will be losing purchasing power every year.

For example, if your portfolio is $500,000, you start with a $20,000 withdrawal in the first year. If the rate of inflation is 3 percent, your withdrawal in the second year is $20,600, $21,218 in the third, $21,854 in the fourth, $$22,510 in the fifth, and so on. Roll that out for a decade or more, and the withdrawals get hefty.

It would be easy to get a 4 percent current income yield from bonds and CDs. It's not so easy to get the 7 percent total return required to keep up with inflation. Settle for a 4 percent total return and, eventually, you'll be spending your principal. Similarly, while there are some stocks that pay over 4 percent in dividends, many stocks pay no dividend.

The vast majority of stocks pay far less than 4 percent. In the current market, for instance, a traditional managed balanced portfolio--- 60 percent stocks, 40 percent bonds---produces an average yield of only 2 percent, according to Morningstar data. The Vanguard Balanced Index fund, in the same period, produced a yield of only 2.9 percent. Either way, it's difficult to get a rising 4 percent annual income.

Q. I recently bought several exchange-traded funds (ETFs) ---this after having owned mutual funds for some time.

Mutual funds are valued at the end of the day at the net asset value of the equities owned by the fund. Is the value an ETF is listed at and trades at related to the value of the equities held by the fund? Or is it a value that buyers and sellers agree to make a trade of the fund shares at that is otherwise independent of the value of the equities held by the fund? ---B. J., by email

A. In a mutual fund, the investment company issues or redeems shares based on the net asset value per share of the underlying portfolio at the end of the day.

An exchange-traded fund is different. Your shares trade at the market price throughout the day, independent of the underlying net asset value of the fund. This may sound risky, but the majority of ETFs trade within a one-quarter of 1 percent premium or discount to their underlying net asset value, most of the time.

This is quite different from closed-end funds whose shares also trade at market prices, not net asset value. Closed-end funds often sell at substantial premiums or discounts to the net asset value of the underlying portfolio.

Exchange-traded funds have avoided this problem by having large trading entities create or dissolve relatively large units of the fund at any time. These traders will create or dissolve these large units whenever there is a profitable gap between the market price and the underlying net asset value of the shares. In Wall Street language, they arbitrage away the spread between market price and net asset value per share. ------------------------------------------------------------------------------------------------

Personal finance writer Scott Burns is syndicated by Universal Press. His twice weekly column appears in newspapers from Boston to Seattle. He is the Chief Investment Strategist for AssetBuilder, Inc. Readers can register at www.scottburns.com. Questions/comments can be posted directly. They can also be sent, without registration, to scott@scottburns.com. Questions of general interest will be answered in future columns and on this blog.

Click on the "Archive" navigation to see other columns. All comments are welcomed and appreciated.
Published Jan 03 2007, 06:00 PM by scottb
Filed under: , , ,

Comments

 

ABModerator03 said:

Hi, Mr. Burns

I am so glad that B.N. ask you about the retirees 4% withdraw question. It has been in my puzzlement for a while.

I feel the same way as B.N. that if you do not use up your investment income each year, you would buildup your principle continuously even with inflation in mind when withdrawing. That is if you have much higher principle to retire with.

For example, If you have a portfolio of over 2 million cash excluding stock, bond, pension and real estate. Assuming you put all 2 million in CDs only and getting an average 4% interest each year. That itself will give you $80,000.00 per year income. If before retirement and after, your total average yearly expenditure is $60,000.00. Each year, your cash principle will grow around $20,000.00 minus the inflation. It is going to take a least 10 years before the 3% inflation catch up with you if you continue spend $60,000.00/year . People can always keep adjusting their way of living so that you will never have to tap into your 2 mil and growing ( it may be small or none) principle.

Isn't that the case?

EYK

p.s. $60,000.00 yearly expenditure I used as an example is spending very freely and luxuriously if you are a disciplined spender and wise with your money.

  

From Scott Burns:

Yes, that's the case. But the devil is in the details. If you have $80,000 of investment income, pay taxes on it, and then spend $60,000, the amount left for reinvestment will be quite small. The less you reinvest, the faster inflation will force you to either spend principal or reduce your spending. The academic exercises in portfolio survival are exercises in calculation that require maintaining constant purchasing power. They do not consider, as you do, that people may adapt to having a slow decline in real purchasing power. As a practical matter, studies show that people tend to consume less as they age, particularly after reaching age 75. This change is NOT the result of having less in assets, it is the result of aging.
January 5, 2007 9:23 AM
 

ABModerator03 said:

B.N. Here is a good way to look at it:

You want your income to provide a constant purchasing power over the years. This means that each month you will take out enough money to buy the same amount of the things you consume. Because of inflation, this amount will continually increase.

To maintain your withdraw rate at 4% of your assets, your principle must also maintain constant purchasing power (or real value). As the dollar becomes less valuable because of inflation, you need more of them to have the same real value.

As Scott indicates, if you can get a 7% total return on your portfolio, spend 4% of that, and reinvest the 3% as a hedge against inflation, and if inflation stays around 3%, you should accomplish this. Do notice the "ifs". A 7% return is never guaranteed, and inflation has historically varied somewhat. You may need to adjust your plans if reality doesn't match this guess.

Don
January 5, 2007 10:26 AM
 

ABModerator03 said:

It seems to me that the emphasis on the 4% withdrawal obscures the basis upon which it is founded. The basis appears to be that the expected total average return on investment will be 7% (4% withdrawal plus 3% inflation).

If one withdraws only the amount of the increase less the amount of inflation, the principal remains the same value in constant dollars. Since the returns will fluctuate, so will the withdrawals. If the maximum annual withdrawals were made, a secondary account to store the excess in the good years could smooth the annual income. If the retirement asset account has a negative return (as it probably will some years) the principal will be eroded unless the negative return plus inflation is made up from the secondary account.

I would not really set up a separate account, but track the results by spread sheet. It may be necessary to dip into the principal (that is what it is for), but the process keeps one current on the state of one's nut.
January 6, 2007 11:10 AM
 

ABModerator03 said:

Scott

Each Sunday I read and enjoy your column in the Seattle Times. This past Sunday, the leading question was regarding a 4% withdrawl rate from retirement nest egg.

In the second paragraph of your answer, you stated "your portfolio needs a total return that is equal to your withdrawal rate plus the inflation rate---if it is to generate a growing income".

I have two issues: one--why do I want my portfolio to grow?--and two--you and most other reponders do not mention that once you start taking a distribution you only have a one time option to change the amount of your distribution.

At 54 1/2 years old, this is what I did--created a spreadsheet---starting amount of 430k--used a 3.5% annualized return--ran it out to 89 years old and backed into a payment that would gradually draw the principal down to less than 100k. I do not want to have a large balance to leave behind---my wife and I want to enjoy life--but leave something beside the value of our residence for inheritance.

My plan is to reevaluate my payment option at 59 1/2 to 62 and make an adjustment then. For what its worth, I do have a pension coming also (started at 55) and will have SS to add.

Comments?

Larry

  

From Scott Burns:

You've put a lot more thought and effort into this than most people. The whole point of the required total return exercise (withdrawal rate+inflation) is to sensitize readers to the return they need to sustain a level standard of living in retirement. It is possible to allow your assets to shrink but it makes targeting more difficult--- they often shrink faster than you expect, particularly if you have equities in a market like 2000-2002. You can learn a lot more by visiting the "portfolio survival" category on my website.
January 8, 2007 10:42 AM
 

ABModerator03 said:

Dear Scott,

When I saw the letter from B.N. I thought, " At last, I will get this 4% rule cleared up." But I am as confused as ever.

Let me ask the question my own way.

I have a $500,000 portfolio. It pays me $12,000 in cash per year in interest and dividends.

How much principal can I withdraw?

1) $8,000 for total cash of $20,000 equal to 4% of the portfolio?

OR

2) $20,000 from principal for total cash of $32,000?

I think the answer is #1, but I am not sure.

Sorry to be so obtuse.

George

  

From Scott Burns:

You can withdraw $8,000, making your total outtake from the portfolio $20,000. If you go to the portfolio survival category on my website you'll see links to information on how and why 4 percent gives you good odds of being able to withdraw a rising amount each year.

You're not obtuse, George. This is tough stuff to get your head around.
January 8, 2007 3:02 PM
 

ABModerator03 said:

Hello, Mr. Burns....

I have two questions, and would appreciate your assistance in helping me to understand the issues.

First, having read your column for a long time, I finally decided to invest in the Vanguard Index Trust 500 Portfolio, believing that I would earn average market returns over time. On 1-14-2000 I invested $20,000 and purchased 147.457 shares of the fund. Now, I own 164.122 shares of the fund, valued at $21,393.30. Schwab tells me that my total cost basis in my shares is $21,510.00. So, even after the rebounds in the market, I'm still in a loss position after these 7 years. How is this possible, considering the growth in the market?

Second, I've read in your column and other places that a general rule for drawing against our accumulated savings in retirement is 4% per year. I'm confused about that, because assuming a rather conservative return on assets of 8% per year, it means that even during retirement one would actually be continuing to grow his assets instead of depleting them. What am I missing?

I would be most grateful for your attention in helping me to understand.

Good wishes... Bruce

From Scott Burns:

Be patient and I'll explain. The annual return on common stocks has been between 10 and 11 percent for more than 80 years. Those 80 years, however, include the Great Depression, the market crash of 73-74, and the crash of 2000-2002. So what you experience isn't a smooth annual 8 percent return. Instead, you experience a roller coaster ride. Had you invested in 1929, your experience would probably have wiped you out. As it was, you invested at the beginning of a major three year decline. Here are the figures for VFINX. As you can see, the first three years were major declines.

2000 -9.06 2001 -12.02 2002 -22.15 2003 28.50 2004 10.74 2005 4.77 2006 15.60

During that time the S&P 500 did well against managed money. It did better than 62 percent of comparable managed funds over the last 3 years, 57 percent over the last 5 years, and 69 percent over the last 10 years. If past experience is a guide,

It will do better than 70 percent of managed funds in its large cap blend category by the time you have been invested for 10 years.

The S&P 500 represents more than 75 percent of all market values in America so it is, for practical purposes, "the market." So you're not falling behind "growth in the market." The only reason the Dow Jones Industrial Average is ahead of its previous market high is the manner in which it is calculated. The S&P 500 Index is just catching up with its old highs.

Bruce

So many thanks for your reply, which was, admittedly, not expected and certainly not at all so promptly. Indeed, given the information you gave me regarding the market performance for the Vanguard Index 500 for those years and working the numbers brings it into focus. I can't say that it pleases me, but at least I'm not left feeling that somehow I'm being singled out for market abuse. lol

You didn't address my other question, that of the commonly suggested maximum withdrawal from our retirement nest egg of 4%. Again, it seems to me that that is a formula that continues to build the retirement nest egg, not to gradually deplete it. If someone weren't intending to leave a significant inheritance, wouldn't it make sense to perhaps deplete the nest egg at the rate of 4% plus whatever the increase was, if any, from the prior year? Otherwise, wouldn't someone who retires with assets valued at $1 million, who earns 8% per year on those assets, but only withdraws 4% (of the original $1 million) actually accumulate a total of $2.6 mil at the end of 25 years?

Again, many thanks for your attention. I'm very grateful, and impressed that you would take the time to address my question.

From Scott Burns:

It's all about the variability of returns. If you were assured of an 8 percent annual return, year in and year out, and you also knew that inflation would average 3 percent, you could withdraw 5 percent a year and have great certainty that you would have an annual income that would rise with the rate of inflation. You could then add some amount of principal withdrawal that slowly reduce your assets. The limitation here is that we don't have a date for dying, so we have to guess about how much additional money we can take.

But life IS uncertain. And so are investment returns. In biology there is something called "the extinction problem"--- it is an event that reduces a population so much that the reproduction rate can't cope and restore the population. Much the same can happen with retirement portfolios--- if you suffer a large loss but continue to withdraw at the same rate, your portfolio will become extinct.   You can learn a lot more about this by reading columns about "portfolio survival", one of the categories listed on the right side of my home page. Statistical types call the problem "variance sink"--- the danger represented to a portfolio by major downdrafts.
January 11, 2007 2:50 PM
 

ABModerator03 said:

Based on your recommendation that retirees withdraw no more than 4 percent a year from their retirement nest egg, a million dollar savings at retirement is not amount to much at all especially if the retiree lives on the coasts. Even if the mortgage is paid for at retirement, a $3500.00 monthly income does not exactly provide one the lifestyle of a 'millionaire'. For younger workers, there might not even be social security checks for them when they retire not to mention that pension is largely a thing of the past. For the average workers in today's economy, to save a million bucks is no small task to start with. Do you have a more encouraging outlook for this group of people? Thank you.

-Patrick

From Scott Burns:

This is one of those things where you can quickly talk yourself into anger, desperation, or both. As great as the problems of Social Security are, the largest and most important social program in America is NOT going to disappear. The worst that could happen is a benefit reduction of about 27 percent. That's serious. But serious isn't the same as leaving town. The biggest issue facing most Americans is the gigantic unfunded liabilities of Medicare. To put it all in some perspective, the unfunded liabilities of Medicare Part D, alone, are nearly twice the unfunded liabilities of Social Security. You can read more about this on my website under Social Security.

Similarly, it is not impossible to accumulate $1 million or more if you are a diligent long term saver and lose a major part of your investment return to the retirement/investment complex and its fees. Save a bit more than $300 a month for 35 years and you'll have about $1 million. That's 10 percent of a $36,000 income, 5 percent of a $72,000 income. If your employer puts up a typical 50 percent match, the amount the employee needs to save is reduced by 1/3.

So here's the formula for success. First, save every year. Second, make sure you get as much as possible of the return on your savings. This means reducing the paychecks of the investment industry middlemen who currently take 2 percent, and often more, of YOUR investment return.
January 11, 2007 5:39 PM
 

ABModerator03 said:

Dear Mr. Burns,

In a recent column, you stated that one should earn more than 7% annually to deal with an annual withdrawal of 4% and an inflation rate of 3%. In my case, half of my assets are in tax-deferred accounts and taxable as ordinary income when withdrawn. Do you have any guidelines or rules-of-thumb as to how to include this type of situation in a calculation aimed at determining what is a "safe" withdrawal rate?

- Jerry

From Scott Burns:  

It should have no effect on the basic math.

You will, however, eventually face the need to make RMDs (Required Minimum Distributions) from your tax deferred accounts. Those distributions will eventually be more than 4 percent a year. As a consequence, you'll be paying taxes on more income. Some people may find themselves in a higher tax bracket because of RMDs.
January 17, 2007 10:47 AM

About scottb

Scott Burns has covered the changing world of personal finance and investments for nearly 40 years. Today, he ranks as one of the five most widely read personal finance writers in the country. Scott began his career as a newspaper columnist at the Boston Herald in 1977 where he was also the financial editor. Nationally syndicated in 1981 and now distributed by Universal Press, the column appears in newspapers from Boston to Seattle. In 1985 he joined the staff of the Dallas Morning News where his column quickly became one of the most widely read features in the paper. He left the Dallas Morning News in 2006 to become one of the founders of AssetBuilder and its Chief Investment Strategist. Burns is a graduate of Massachusetts Institute of Technology (1962). He has written four books, including "The Coming Generational Storm" (MIT Press, 2004) coauthored with economist Laurence J. Kotlikoff. His fourth book, also coauthored with Kotlikoff, will be published this spring by Simon & Schuster. "Spend Til' the End" uses consumption smoothing to demonstrate the errors of conventional financial planning. His business experience includes working as a staffer for a major consulting company and service as a director and audit chairman of a NASDAQ listed manufacturing company. He and his wife divide their time between Dallas and Santa Fe, New Mexico.
Copyright © 2007 - 2008, AssetBuilder Inc - DFA Advisor. All Rights Reserved. View our Terms & Disclaimers.