In the last post “Is 2 Percent the New Safe Retirement Withdrawal Rate?”, we explored how some experts have knocked the conventional 4% retirement withdrawal rate in favor of figures as high as 7% and low as 2%. In conclusion, I demonstrated using a simple linear example how I thought a 3% withdrawal rate with an assumption of 6% growth was my personal preference. My reasoning was because it offered a high probability for steady returns and seemed to maintain portfolio integrity even after adjustment for inflation.
So what’s the problem?
• Rule of thumb calculations are okay for estimations. But in real life, they hardly ever play out the way they do on paper. Think about it. In our previous example, the portfolio always grew year over year by 6%. But portfolios don’t go up and up forever. And when they go down, they can have a bigger impact on your portfolio than you’ll expect.
Consider the following scenario:
• Year 0: You start your retirement with $1,000,000 and withdraw 3%. So you take out $30,000 and are left with $970,000. Your brilliant model predicts that at the end of Year 1 you’re money will grow by 6% and you’ll have $1,028,000.
• Year 1: Oh no! The market tanked by negative 10%! Now your balance drops to $873,000. You withdraw another 3% of $26,190. Now your balance is all the way down to $846,810. That’s over $150,000 lost in just the first year! At this rate you’ll be broke in less than 10 years. How’s that 6% model treating you now?
So if you can’t generalize some constant rate of return to keep your proverbial cookie jar from running out of cookies, then what are you supposed to do to predict how long your retirement funds will last?
A Better Approach:
The truth is that your guess is just as good as anyone else’s when it comes to what the market will do next year, the year after that, and so on. In reality, you could take my example from earlier and put in any random number for the return rate each year.
So how can we build this into our model and find a way to generate random numbers automatically?
Using a Monte Carlo Simulation:
This is where a thing called a Monte Carlo simulation comes in. A Monte Carlo simulation is when you use random sampling to run a computer model to test your theory.
That’s exactly what we plan to do – test our theory about whether or not we’ll run out of money during retirement.
To begin, download my Microsoft Excel file: My Money Design Monte Carlo Worksheet Rev1
The picture above is an example of just one Monte Carlo simulation from my Excel worksheet (and because it’s made of our random numbers, you’ll never see it look like this ever again). As you see, it shows you how your money will do over the next 50 years. What’s our goal?
• Don’t go below $0 and run out of money!
The beauty of this experiment is that you can do it hundreds of times to try out an infinite combination of results. Every time you click “F9”, the random numbers update and the graph will change. Download it and try this out for yourself! It’s a lot of fun.
How Does It Work?
• You can enter any Starting Balance you want. I have it set to $1,000,000 to start with.
• You can enter any Withdrawal Rate you want. I have it set to my ideal 3%, but feel free to experiment with higher percentages. I think you’ll find that you’ll go below $0 more often the higher you set that number.
• Inflation has been set to 3%. You can change this if you want, but this is a pretty accepted figure.
• The random numbers in the “Return Rate” column come from the Return Rate Mean and Sigma variables based on the empirical rule (if you’re dying to know what that means, click here to read about it on Wikipedia). These figures come from real S&P 500 data between 1950 and 2012 under the Reference tab within the same Excel worksheet. If you want to change these, go ahead.
Adjusted for Inflation – For Your Convenience:
We will want to increase our withdrawal each year to account for the rate of inflation. This has already been built into the equations and model.
How Did You Do?
So after downloading my Excel file and trying it out multiple times, how did you do? Did any of these trials lead to a negative balance? What if you raise the withdrawal rate? At what point do you stop feeling safe about how much to withdraw?
Photo Credit: Microsoft Clip Art