It’s easy to make a plan for spending retirement savings that looks good on paper. But there are many unknowns when it comes to investing. A little bad luck in the first few years of retirement can sink your plan.
Proper stress-testing of a retirement plan is the main theme of Jim Otar’s book Unveiling the Retirement Myth (available online for a limited time here). Instead of testing a plan with average return figures for stocks, bonds, and other asset classes, Otar simulates retirement plans using actual market data since 1900. These simulations check the results when a virtual copy of you retires in each year to see what happens.
Suppose you have a $1 million nest egg and plan to withdraw $50,000 rising with inflation each year. If you assume your investment returns will be 5% above inflation each year then the $1 million will last forever. But this is unrealistic. Returns vary unpredictably. This retirement plan that looks so great shrivels up when Otar’s analysis shows how often you’d run out of money before age 90.
As I explained in an earlier post, I have concerns about the way that Otar reduces dividends in actual historical returns before using them, but the basic idea of checking a retirement plan against historical data is useful.
According to Otar, those who create a single projection of a retirement savings balance aren’t necessarily naive: “most of these plans are produced for only one reason: to sell dreams. Many financial planners do that, many stockbrokers do that, mutual funds do that, hedge funds do that, many pension managers do that.” I guess it’s hard to sell a financial plan to a client if it shows a 25% chance of the client eating cat food.