Sixty-nine year old Janet Smith feels like a swimmer who just escaped a riptide. Relieved, she told me, “I finally sold my house. Buying that house was one of the biggest mistakes I ever made.” I’ve changed Janet’s name to protect her identity. But plenty of people can relate to her story–and her new dilemma.
In 2006, she bought a $900,000 home in Topanga, California. It was near the peak of the housing market. “I had the house inspected before I moved in. But I soon had to shell out thousands of dollars in repairs. When I complained to the inspector, he basically said, ‘tough luck.’”
The home’s value soon cratered during the sub-prime mortgage mess. It also continued to hammer holes in her savings account. “It was just one repair after another,” she says. Her mortgage interest rate was high, compared to today’s low interest rates, and she paid about $12,000 a year in property taxes.
After multiple attempts to sell it, Janet was finally able to celebrate this week. She sold her home for about $1 million. After paying real estate fees and her outstanding mortgage, Janet will net about $220,000. She also owns a portfolio of stocks. If she adds her home’s net proceeds to her investment portfolio, she’ll have about $500,000. “I only collect $790 a month from Social Security,” she says, “so I need my portfolio to provide a regular stream of income.”
Plenty of financial advisors would like to help Janet. But she’s cautious. “I can’t afford to make another mistake, so I’ve been looking for decent products with a low-cost investment firm.”
Janet asked Vanguard about a fixed annuity option: a predictable stream of income that doesn’t fluctuate with the stock market. The Vanguard rep asked Janet a few questions before calculating that her payout would be $34,000 a year on a $500,000 investment. That’s a 6.8 percent annual return.
But what if Janet invested her proceeds in a diversified portfolio of low-cost index funds instead? Many retirees are familiar with the 4 percent rule. Several back-tested studies say it’s the maximum amount that retirees can withdraw from an investment portfolio each year, while providing the highest statistical odds that they won’t run out of money during a 30-year retirement. But 4 percent of $500,000 is just $20,000 a year. That’s a lot less than the $34,000 she could earn with Vanguard’s fixed annuity.
The two options, however, are like comparing cats and dogs. The fixed annuity provides higher annual income. But the payout is fixed. It doesn’t keep pace with inflation, nor can the money be bequeathed. Theoretically, Janet could buy the annuity for $500,000, die two years later, and the money would be gone forever. Her heirs wouldn’t get a penny.
In contrast, selling 4 percent of a portfolio provides lower initial spending power. But withdrawals can be increased to cover the rising cost of living. Unlike the fixed annuity, Janet could also bequeath the portfolio’s proceeds when she dies. That’s why her 28 year-old nephew Jimmy might say, “Don’t buy the annuity Auntie Janet!” But we’re not asking him which strategy is best.
In fact, without a working crystal ball, we can’t know which is better. But we can try to create an apples-to-apples comparison. If Janet puts her $500,000 in a diversified portfolio of low-cost index funds and withdraws $34,000 a year, that would equal Vanguard’s fixed annuity payment.
But would her money last the duration of her retirement?
According to Social Security’s life expectancy data, a healthy 69 year-old woman is expected to reach her 86th birthday. One in ten can expect to live to 95 years of age. That’s why Janet’s money might need to last 30 years.
Over the past 30 years, a diversified portfolio of low-cost index funds would have averaged a compound annual return of 8.31 percent per year if it were invested 40 percent in U.S. stocks, 20 percent in international stocks, and 40 percent in U.S. bonds.
If Janet averaged a compound annual return of 8.31 percent over the next 30 years, she could withdraw $34,000 a year and bequeath almost $2 million to her heirs if she died at age 99.
But if she retired right before a market crash, it wouldn’t look as rosy. Assume Janet retired in 2001. That year, the S&P 500 dropped 12.02 percent. The following year, it dropped another 22.15 percent. Just six years later (2008) U.S. stocks tumbled 37.02 percent.
$34,000 Annual Withdrawal From A $500,000 Portfolio
January 2001 – March 31, 2018
|Year||Annual Withdrawal||Remaining Balance|
|Total Withdrawn||Remaining Balance|
In total, she would have withdrawn $612,000 from her initial $500,000 investment. And if she died at age 86, her heirs would inherit the remaining $296,413. If she died before she turned 86, her heirs would have inherited even more.
Retirees, however, shouldn’t withdraw $34,000 a year from a $500,000 portfolio. I just used this example to make a crude comparison.
If you know how long you’ll live or how stocks will perform, your decisions will be easy. But nobody has that gift. That’s why you’ll need to ask yourself, “How will I sleep at night if I make Decision A over Decision B? Janet will put her proceeds into a portfolio of low-cost index funds. But your decision might be different–and that wouldn’t make it wrong. After all, personal finance is always going to be…well…personal.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas