Retire at the Coffeehouse
- bob90245
- bob90245
- bob90245
- bob90245
- bob90245
- bob90245
- bob90245
- bob90245
- bob90245
- bob90245
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» bob90245 - Introduction
.Welcome to the “Retire at the Coffeehouse” message board. This topic is close cousins to these other threads:
Critical Mass - Care and Feeding For Once Attained
http://www.suite101.com/discussion.cfm/i...
Retirement Planning
http://www.suite101.com/discussion.cfm/i...
Slice and Dice
http://www.suite101.com/discussion.cfm/i...
Discussions on the above message boards are of a general nature. However, this message board is dedicated to a specific strategy:
To apply a “safe” withdrawal rate from a retirement portfolio comprising index funds from multiple asset classes.
This discussion will include:
• Increase annual withdrawal to maintain inflation-adjusted purchasing power• Historical returns of common asset classes
• Coffeehouse portfolio
• Sample withdrawal strategy to minimize effects of “Reverse Dollar Cost Averaging”
• Real-world example using Vanguard index mutual funds
-- posted by bob90245
» bob90245 - Chapter 1: Safe Withdrawal Rate
.After reading a few books and numerous articles on the subject (listed below), I have a deeper understanding of what’s involved with withdrawing from a retirement portfolio. This article and the articles in this series will go into great detail with many examples.
Historical Rates of Returns
The first step to understanding the process is to make reasonable assumptions about rates of return. In the next few chapters, I will review historical rates of returns for stocks, intermediate-term bonds (5 years), cash and inflation. Briefly, these can be summarized with approximate numbers:
Large-cap stocks 11%
Small-cap stocks 12%
Bonds 5%
Cash 4%
Inflation 3%
Growth Rate for a Balanced Portfolio
A reasonable assumption for a balanced portfolio would be as follows:
• Have 50% in stocks with an expected average rate of return of 10%.
• Have 50% in fixed income (bonds and cash) with a combined expected average rate of return of 4%.
With these assumptions, a balanced portfolio can roughly achieve an overall average rate of return of 7% calculated as follows:
50% stocks x 10% = 5%
50% fixed income x 4% = 2%
So adding 5% return from stocks plus 2% return from fixed income would generate an overall average return of 7%.
Calculating a Withdrawal Rate
So now we have two key numbers. First, if we want our nest egg to keep pace with inflation, it must grow each year by 3%. (This assumes that your expenses will grow more or less in line with inflation. This topic can get very complicated. For example, health care expenses might grow much faster at a later stage in retirement. But for the sake of simplicity, I will use 3% in order to demonstrate this example.)
Second, we have assumed that our nest egg can grow at an average annual rate 7%. The difference between the average growth rate (7%) and the average inflation rate (3%) is what we can safely withdraw (4%).
Written as a formula:
Initial withdrawal rate =
(Portfolio average annual growth rate) – (Average inflation rate)
As I will show in the following chapters on historical returns, we can expect stocks to experience good years and bad years. So we need to be smart about how we take withdrawals from the portfolio. This is because withdrawing from declining stock funds can deplete your portfolio sooner than necessary. I explain this concept of “reverse dollar cost averaging” in this article.
How Large Should Your Retirement Nest Egg Be?
The answer may be shocking and surprising. Let me give you this example. (I’m assuming no other sources of income such as pensions or social security). If we withdraw 4% from the portfolio each year and we want to spend $40,000 in the first year of retirement, then the retirement nest egg will need to be $1,000,000. That’s right, a million dollars! Here’s the math:
$1,000,000 x 4% = $40,000
Alternatively, you will need 25 times the first year’s amount you require from your nest egg. 25 is the inverse of 4%.
Further Reading
In contrast with the large number of books written on how to accumulate a retirement nest egg, there are precious few books written on a strategy showing how to withdraw money from your nest egg and make it last your lifetime. And none really satisfies me in a way that I can fully recommend. This is the motivation for me to write these articles. There are many pieces of the puzzle from many different books and internet articles. And it’s taken me a long time to make all the pieces from these many sources fit together in a manner that I can be comfortable with. With that said, here are three books. Some ideas I found useful, some not so useful.
The Grangaard Strategy: Invest Right During Retirement by Paul A. Grangaard
Plan Right for Retirement With the Grangaard Strategy by Paul A. Grangaard
Buckets of Money : How to Retire in Comfort and Safety by Raymond J. Lucia
You can read many different articles on this subject at this link.
http://www.suite101.com/discussion.cfm/i...
In the next few chapters, I will review historical rates of returns.
-- posted by bob90245
» bob90245 - Chapter 2: Large-cap stocks
.I’ll start this review with large-cap stocks as represented by the S&P 500. Data comes from Ibbotson. You can also find the data in
The Grangaard Strategy: Invest Right During Retirement by Paul A. Grangaard
This site also has historical data:
http://www.gummy-stuff.org/returns.htm
<img src=http://www.geocities.com/bob90245/SP500A...>
As you can see in figure 1, annual returns are quite variable. But when taken over the whole period, the average annual return is around 11%.
Figure 2 shows a histogram of the returns. The blue numbers correspond to the percent of the pie. There were a total of 78 years in the entire period. For 5 out those 78 years (or 6%), annual returns were below -20%. For 23 out of 78 years (or 28%), returns were negative. For the optimist, nearly 3 out 4 years were positive.
-- posted by bob90245
» bob90245 - Chapter 3: Small-cap stocks
.Let’s now examine small-cap stocks. Again, the data comes from Ibbotson.
<img src=http://www.geocities.com/bob90245/SmallA...>
You can see in figure 3 that the annual returns are more widely dispersed than for large-cap stocks in figure 1. Over the entire period, the average annual return for small stocks was approximately 12%.
Figure 4 shows the histogram of small-cap returns. Here we see the manifestation of the wider dispersion of returns. There are more years of negative returns (18 out of 78 or 32%). However, this was balanced out by more years with returns of 20% or higher.
-- posted by bob90245
» bob90245 - Chapter 4: Intermediate-Term Gov. Bonds
.Next, let’s take a look at the annual returns for intermediate-term (5-year) government bonds. Again, the data comes from Ibbotson.
<img src=http://www.geocities.com/bob90245/BondsA...>
Figure 5 shows the combined results of income plus capital gain or loss. (The principle value of a bond will rise or fall with changes in interest rates.) An investor holding an intermediate-term bond mutual fund would likely experience similar volatility. Over the entire period, the average annual return was approximately 5%.
Figure 6 shows a histogram of the returns shown in figure 5. Eight out of the 78 years in the study (or 10%) had negative returns. Fortunately, an investor wishing to eliminate volatility in the bond component of their portfolio can easily do so. This can be accomplished by constructing a bond or CD ladder. Bankrate.com has an article on how to construct a CD ladder. Click here to learn more.
-- posted by bob90245
» bob90245 - Chapter 5: Cash and Inflation
.The last series of historical returns will be for cash and inflation. The data shown in figure 7 comes from Ibbotson and represents the annual returns for 90-day treasury bills. Over the entire period, the average annual return was approximately 4%.
<img src=http://www.geocities.com/bob90245/BillsA...>
The final chart (figure 8) shows the annual change (year-over-year) of inflation. The data comes from the Bureau of Labor Statistics. For you data hounds, you can view the raw data here.
<img src=http://www.geocities.com/bob90245/Inflat...>
For the entire period, inflation ran at an average annual rate of 3%.
-- posted by bob90245
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