Your Retirement Plan is Doomed to Fail

When it comes to retirement planning there are really only two approaches:

  1. The Probability Based Plan Approach which uses the Safe Withdrawal Rate OR
  2. The Safety First Plan Approach

The problem with the Probability Based Planning Approach

Probability Based Planning uses Monte Carlo Simulations to predict within a certain range, a high probability of success.    Eg) there is 95% chance that if you will earn X% on your investments and live Y number of years in retirement and take an income of Z you will not run out of money.

Would you get on a flight with your family that after various simulations had a 95% chance of not running out of fuel?   Or would you prefer the flight that had zero chance of running out of fuel?

What is a safe withdrawal rate?

Probability Based Planning uses a “Safe Withdrawal Rate.”    A safe withdrawal rate is the rate that financial experts and economists say that you can withdrawal from your retirement savings and not run out of money.   Historically the industry has used a safe withdrawal rate of 5%.    

This means that if you have accumulated $1,000,000 in retirement assets, the experts believed you could take out 5% a year, or $50,000 a year and not run out of money.     Factors such as market risk, inflation, taxes, living a very long time, changes in standard of living etc. are at play and 5% was considered the safe number.

Probability based financial plans are set up to fail

Let me show you a real life numbers example.     Here are two scenarios.   In Scenario one, Bob retires at age 65 with a million dollars in 1995.   He lives on an income of $50,000 a year.     At age 80 he still has $1.6 Million dollars left.    This is based on the actual performance numbers of the TSX from 1995 onward.

Bob has a brother Steve who is 5 years younger.   Steve retired at age 65 in 2000.    He followed Bob’s strategy of living on $50,000 a year and investing his money in the TSX.   At age 80 however, Steve only has $686K left.     This is a $1 Million dollar difference in savings at age 80.

Bob has a brother Steve who is 5 years younger.   Steve retired at age 65 in 2000.    He followed Bob’s strategy of living on $50,000 a year and investing his money in the TSX.   At age 80 however, Steve only has $686K left.     This is a $1 Million dollar difference in savings at age 80.

Do you think Steve is going to feel comfortable continuing to live on $50,000 a year?    How would 2 down years affect his portfolio?   What if Steve has a spouse that will also depend on the money?   Or if he would like to leave some money to his children or a charity?

During the accumulation phase of your life as you save for retirement volatility can work in your favour – when markets are down you buy low.    However, in retirement, when you are withdrawing from your plan it is a real problem.   You have to sell high.  You have to sell a greater percentage of your portfolio to live on the same amount of money.  Market volatility is a financial disaster in retirement … I cannot stress this enough.

The 5% Safe Withdrawal Rate is no longer safe.

Monte Carlo simulations aside, the industry is recognizing that the 5% Safe Withdrawal Rate is no longer safe.    With bond yields well below historical averages and likely here to stay we cannot expect to achieve portfolio returns even remotely similar to what we have seen in the past 30 years.     And given most investors will lower their exposure to higher yielding equities in retirement academics are now realizing even a 4% withdrawal rate has only a 50% probability of success over a 30 year period.    The new Safe Withdrawal rate is likely less than 3%.     So now that million dollars that Bob and Steve saved will only provide them with $30,000 (and a 95% chance of success to boot!)

Canadians need to be preparing themselves for lower returns in retirement.   And this means that the “Safe Withdrawal Rate” will need to come down significantly.

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The financial industry spends millions on showing us how to accumulate money for retirement and relatively few efforts on showing Canadians how to draw down their income in retirement.   

So now that you know the perils of Probability Based Financial Planning would you be interested in hearing about the Safety First Based approach? 

Would you like a retirement plan in which you hope you can win, or a retirement plan that guarantees you can win?