Key Takeaways
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Goal Setting
In our last post, we examined the notion that historically the markets are far better than they are worse. We looked at rolling 5-year periods on the S&P 500 index and how often markets lost value vs gained. As stated in that article the markets are rarely negative for long periods, and in those few cases rallied in the following years rewarding faithful investors for their patience. After that article, we received several questions relating to portfolio sizing and income production. So, in this post, we will discuss saved values, and income replacement topics. Before the math, let’s talk about the philosophy of how income planning works.
Financial lives occur in three phases:
- Accumulation- This is the phase where we plant seeds, hold our breath, and take the most risk. We allow time and compounding growth to work their magic. Ideally, this phase begins as we start to save and ends for most in the last several years of their career.
- Protection- Generally, this is usually the shortest phase where we have grown the nest egg but do not require it to produce income yet. This phase follows the accumulation phase and extends until income is required on the portfolio. Commonly, this phase is marked by slightly less risk in the portfolio in preparation for income needed in the next phase.
- Distribution- We all look forward to using the dollars that we’ve saved to live, give, and enjoy the fruits of our long lives. This phase usually contains heavy estate planning and a shift to income investing vs growth.
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life Cycle of Financial Retirement
Data Source: Capital Wealth Advisors
Using the chart above, we all approach retirement with two things, a finite amount of dollars (unique to every family) to spread over the amount of time spent in retirement. The goal is to ensure that the pile of assets is tall enough to stretch over what we believe will be our lifespan. It would be wonderful if things were as easy as the straight line presented in this chart, but many confounding and corrosive things make financial planning essential. A short list of those is – fickle markets, taxes, inflation, emergency expenses, incapacitation costs and so many more. As we move along in this piece, we will cover some of these items.
HOW MUCH DO I NEED TO COVER EXPENSES?
So, how much is enough? This is an age-old question that is relative to every person. Many of the families we work with are looking to pay the bills, enjoy life, and leave something to their dear ones when they pass away. Monetarily that total may look different to us all. The reason I start here is that I think that we have to separate greed from need. I doubt anyone reading this article couldn’t figure out what to do with more than they have now. Also, everyone I have personally ever partnered with would prefer huge gains with little or no risk, but sadly, that’s not the way the investing process seems to work. Let’s look at what the census tells us about median incomes in America then look at how to generate that kind of income.
How much do average Americans make?
| Income Source | Median Level | Data Source |
| Wage Income for two Earners1 | $74,580 | (Bureau, 2023) |
| Social Security for two Earners2 | $22,884 | (What Is the Estimated Monthly Benefit for a Retired Worker? Customer Self-Service, 2019) |
From a goal perspective, what kind of balance is required to support replacing this kind of income? That starts to get to the heart of risk, sustainability, growth, and loss. From a planning perspective, we have to look at what withdrawal rate you are comfortable with using against your portfolio value. There have been many studies done on appropriate withdrawal rates. Dr. Wade Pfau from the American College of Financial Services has written to follow the original trinity study that spawned the very popular 4% rule. It bears mention that this “rule” is at best a guideline and has been studied and argued extensively. We aren’t here to debate the efficacy of the guideline, merely to reference its popularity as a starting point. So, we will start with 4% and show a few other rates for illustrative purposes. It should be mentioned that the S&P 500 index averages about 10-11% over an extended period so we will not use rates higher than that.3 Also, we will mention that the higher the withdrawal rate the less sustainable it may be due to volatility of balances and the sequence of market returns you happen to live through. We will illustrate that later in this piece.
Income Replacement Table
| Income Replacement Table 1 (Median Income Replacement) |
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| Income Replacement Dollar Value | Withdrawal Rate | Required Balance to Sustain Withdrawal Balance |
| $ 74,580.00 | 4% | $ 1,864,500.00 |
| $ 74,580.00 | 6% | $ 1,243,000.00 |
| $ 74,580.00 | 8% | $ 932,250.00 |
| $ 74,580.00 | 10% | $ 745,800.00 |
| Income Replacement Table 1 (2x Median Income Replacement) |
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| Income Replacement Dollar Value | Withdrawal Rate | Required Balance to Sustain Withdrawal Balance |
| $ 149,580.00 | 4% | $ 3,739,500.00 |
| $ 149,580.00 | 6% | $ 2,493,000.00 |
| $ 149,580.00 | 8% | $ 1,869,750.00 |
| $ 149,580.00 | 10% | $ 1,495,800.00 |
How much do average Americans make?
As you can see in the charts above, the harder you are willing to work on your portfolio, the smaller it needs to be to generate the desired amount of income. The challenge is that the portfolio needs to last a lifetime and ideally grow during the distribution phase. For example, if you took 10% annually from a static portfolio with no growth, you would exhaust the dollars in 10 years. That strategy fails for folks who plan to live longer than 10 years. So, these charts beg a question about the effects of fickle markets and growth rates on the sustainability of withdrawal rates. In the next section, we will examine two decades of market outcomes over two rates of distribution.
Fickle Markets and Their Impact on Different Withdrawal Rates
• Now that we have observed markets and income generation concepts, how do these overlap?
• What effect does the sequence of returns that occur have on the income that we can expect?
This is one of the real wild cards of this process. For this example, we used one very calm decade and one very tumultuous (See Appendix ). The 10 years following the 1987 correction (1988-1998) were historically tranquil and productive. If you look at the 10 years following that from 1998 through 2008 this decade contains 4 negative years. The only period with more negative years was the stretch between 1929 and 1939. That decade contained the Great Depression and the beginning of World War II and felt a little anomalous for this purpose.
These two charts layout from left to right the year, Sp500 returns, and then the effects of a 4% and 6% annual distribution. Chart 1 covers 1988-1998 and Chart 2 covers 1998-2008. The outcomes couldn’t be more different. In chart 1 the markets are good enough to cover needs and grow at a healthy clip. At the end of the observed period, the portfolio grew from $2,000,000 to $8,628,818 at a 4% withdrawal rate, and $6,845011 with a 6% withdrawal rate. Both would be welcome outcomes for most. In chart 2 the results are less desirable. The portfolio falls in value over the period because the distribution hinders the portfolio’s ability to recover. The income generated in the earlier period is over 6 times that of the latter period. A very stark difference. It is alarming that there can be so much difference between consecutive decades.
Conclusion
What actions should be taken in light of this data? What truths can be gleaned from this research? Sadly, income planning lacks one universal truth. As we have submitted over and over in this blog, each family is unique and needs to think about planning based on their facts and circumstances. That said, distribution rates matter. The lower the demand on the portfolio the better you are arithmetically equipped to weather negative returns. Also, adjusting your income to the markets annually is critical to the longer-range success of the portfolio. The timing of large distributions matters as well. It might be wise during a recession to vacation in St. Louis versus say, St. Lucia. Your portfolio would be weathering a smaller expense during the downturn and saving the larger spend for a better time in the economy. Good strategies and sound investing do help a lot to smooth the ups and downs of the markets. That is why we go to such lengths to provide well-researched strategies for our clients. Hopefully, this post causes you to think about how you spend your savings, and how you see the economy. Investor behaviors drive so much of their end results. We believe that informed investors can make more rational choices and lead to more fulfilling retirements. If you find yourself looking for support in considering these questions, we’d love to engage you in the discussion.