Planning for Financial Future: Rules of Thumb vs. Structured Framework

The financial planning industry has moved away from targeting total portfolio value needed at retirement to annual income needed at retirement.  The standard quote from the industry is now 70% to 100% or a participant should save enough to generate income from their savings (offset by other sources of income such as Social Security) in the range of 70% to 100% of annual pre-retirement income.  As an example, if you make $60,000 per year, then you can expect to need somewhere between $42,000 to $60,000 per year in retirement.  Very similar to other rules of thumb, such as the 4% rule, this 70% to 100% needs to be further analyzed within the context of each individual or household.

Back in 2005, Moshe A. Milevsky and Chris Robinson wrote a piece published in the Financial Analysts Journal (Volume 61, Number 6) titled “A Sustainable Spending Rate without Simulation.”  In that paper, they quote the Nobel Laureate William F. Sharpe that using “fixed returns and fixed dates of death is ‘financial planning in fantasyland.’”  Professor Sharpe’s point is that future returns and date of death is unknowable and should, therefore, be thoughtfully looked at with the use of probabilities and statistics.  In their paper, Milevsky and Robinson provide an interesting way of thinking about the question of retirement income needs.  They point out that the retirement income needed question is best described using three factors that when combined help to better gauge the “probability of retirement ruin.”  These three factors are:

1. spending and consumption
2. asset allocation and investments
3. health, age, and mortality

This triumvirate of factors helps one to better understand choices within a probabilistic framework.

The three factors are simple to understand:

• Spending and consumption: the more you spend, the more you need to have saved
• Asset allocation and investments: the more risk you take, the more likely you are to have large drawdowns that impair future income
• Health, age, and mortality: the longer you live, the more money you need to have saved

Again, these three factors by themselves are very straightforward to understand.  The power of this method rests on combining the three factors together to help retirees calculate how much income potential they have based on their account balance and the level of risk to take in their investment portfolio.  The paper is heavy on math, specifically integral calculus, so we won’t dig too much into that; however, the result is a simple equation that combines expected portfolio return, the riskiness of that portfolio, and the mortality table.  The resulting number provides the “probability of ruin” or the chance that a retiree will run out of money.  Below is an example:

Highlighted in yellow in the chart below is an example of a person on his/her first day of retirement.  This person is 65 years old and has a nest egg of $1,000,000.  The numbers under the heading “Real Annual Spending per $100 of Nest Egg” are annual consumption of that nest egg from $2 to $10 (or 2% to 10%).  The numbers below that range are the probability of ruin (or running out of money).  This 65-year-old just retired person has approximately a 9.4% chance of running out of money using the 4% rule.  We should also add that these numbers assume a 100% equity portfolio with an expected real return of 7% and volatility of 20%. 

The numbers change with a more balanced portfolio of 50% stocks and 50% bonds.  The probability of ruin at a 4% withdrawal rate is 9% (highlighted in yellow in the table below) with this balanced portfolio with an expected return of 5% and portfolio volatility of 12%.  The table below also from the Milevsky and Robinson paper demonstrates further the relationship between consumption and portfolio risk and return:

The above table shows that the probability of ruin is smaller at lower consumption levels.  What is also interesting is that the higher the consumption level is the more risk you need to take with your portfolio.  For example, look at the $6 of $100 Nest Egg line.  The lowest probability of ruin is 20.40% under the column of 7% portfolio return with a volatility of 17% (which in their example is close to an 80% equity portfolio). 

Let’s bring all this back to the 70% to 100% of annual income rule of thumb.  If you had an annual income of $100,000 before retirement, this rule of thumb suggests that you may need somewhere between $70,000 to $100,000 of annual income in retirement.  If you have a nest egg of $1,000,000, then using the table from the Milevsky and Robinson paper, that $70,000 per year of annual income using an all equity portfolio leads to approximately a 27.6% chance of running out of money.  I would take a wild guess that most people would consider that to be too high of a chance of running out of money.  To reduce the risk of ruin, you would need to reduce consumption, which could also allow you to take less risk.  For example, reducing consumption down to $40,000 per year would reduce risk of ruin down to 8.8% with a portfolio that is about 60% stocks and 40% bonds.  (The example in this paragraph does not take into consideration income from other sources such as Social Security nor does it account for the impact of taxes.)

Instead of using rules of thumb, participants would be better served using a more rigorous framework as proposed by Milevsky and Robinson. 

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