Math, Not Market Corrections, Are The Real Threat To Your Retirement Dreams

Posted On February 13, 2018 3:54 pm

The recent volatility in the stock market has been a major wake up call for many investors. After over a year of freakishly low volatility (biggest draw down in 2017 was 3% from all time highs), stocks have proven that they don’t in fact only go up. A friend of mine recently shared something that he heard from a broker he knew. On Thursday February 8th, the day the market closed at its lowest point (so far), a 60 year old grandmother came into this broker’s office and demanded that her 401K be pulled out of stocks.

This is literally the worst possible thing she could have done, especially since she doesn’t plan to retire for another 10 years. Not just because the current correction is purely technical in nature (nothing to do with economic or corporate earnings fundamentals), and so likely to end soon. The fact is that over any significant length of time the stock market has proven to be the most resilient, and absolute best wealth compounder ever discovered.

Rolling Average Total Returns Of The Stock Market Over Time By Time Frame

In fact, there has never been a long-term (20 year or longer) period when the market failed to go up. Not even those who bought at the very top of 1929’s insane bubble failed to make money by 1949. And that’s even if they failed to take advantage of the best values ever seen by any investors, anywhere, at any time, by dollar cost averaging into the crash.

In the case of this frightened elderly woman? Given her 10 year time frame, her odds of her 401K being higher within 10 years was 94%. In fact, given that this historical data is skewed by the Depression (which we’re not likely to repeat), the odds of making money over the next decade are probably closer to 100%. But here’s the thing that most people fail to realize about proper retirement planning. Many people agonize over the proper time to retire, where to retire too, and what investments to own in their retirement portfolio. While all of these things are important, by far the most important is simple math.

For example, a popular rule of thumb for retirement planning is called the 4% rule, which is based on a 1994 study by William Bengen that found that a 60/40 portfolio of stocks and bonds would be able to sustain 4% annual sales (adjusted for inflation) and not run out of money for at least 30 years. Basically the idea is that your portfolio is like a pension fund. The growth of the portfolio will be enough to ensure that your income in retirement lasts in perpetuity.

Another version of this rule, and one that I personally recommend, is to trust your retirement portfolio to a well diversified, high-quality portfolio of high-yield companies. This is because, if you can build a safe 4% or even 5% yielding retirement portfolio (which I am doing myself), then you can enjoy all the income you need, without ever having to sell a single share. This makes you 100% price insensitive, because the only thing that matters to you is that the dividends are safe, and growing faster than inflation (my personal portfolio dividend growth goal is 7%, about 2 to 3 times faster than inflation).

Basically this means that if you entrust your retirement to something like a low cost index ETF like SPY, VOO, or SCHB, the low yield means you’ll likely have to sell occasionally, and that means that you will have to worry about whether the market is in a downturn when you do. So here’s the best way around that. Maintain 3 years worth of living expenses (supplemental to social security) in cash, but don’t touch it. Rather use this cash reserve to draw on (and keep following the 4% rule) if the market is in a correction or bear market.

Source: First Financial

Why 3 years? Because the average correction (10-19% fall from all time highs) lasts just 14 weeks, and brings the market down by 12% to 13%. Bear markets (20+% declines from all time high) last longer, an average of 1.4 years and reduce prices by 41%. So by maintaining a 3 year emergency cash reserve you can hopefully ride out the decline, and only sell after the market has had time to recover.

BUT whether you decide to entrust your retirement income to a low risk, high-yield portfolio or just run of the mill index funds, at the end of the day the secret of retirement is that what you want doesn’t matter, at all. That’s because no matter what strategy you choose, at the end of the day math, not desire, determines when or even if you can retire.

For example, the average retirement savings for an American age 56 to 61, is $163,577. The average social security benefit, per person, is $1,329. So the average couple would be getting $2,658 a month from social security, which is only designed to replace just 40% of one’s pre-retirement income. Standard retirement theory is that your retirement expenses will be 20% lower than when you were working. This may or may not be true, especially given that the average out of pocket medical expenses during retirement are between $123,000  and $133,000, per person, and that’s just medicare premiums! Deductibles and long-term care (retirement home) are extra.

In other words, you have to assume (and budget for) expenses that may be equal to, or even greater than your living expenses during your career. And those medical expenses, generally go up every year, both do to failing health and rapid medical inflation. So that $163,577 retirement portfolio? Well 4% of that is just $6,543 a year, or $545 a month. Whether you get that in dividends, or capital gains (from selling shares) $545 a month isn’t going to let anyone retire in comfort or even security.

This means that if you dream of retiring early (such as 62, the youngest age you can file for social security), you had better make darn sure you have the portfolio to back that up. Or to put another way, retirement math is a harsh mistress, that doesn’t care about what we want, or even need. At the end of the day you either have saved enough, for long enough, and earned sufficient long-term returns, or you will have to work longer, take a major hit to your standard of living, or both.

Fortunately there is a way to avoid such dire consequences, which I will elaborate on in following articles.

Photo: “Calculating Taxes Up And Down” by kenteegardin is licensed under CC BY-SA

About author

Dividend Sensei
Dividend Sensei

I'm an Army veteran and former energy dividend writer for The Motley Fool. I currently write for both Seeking Alpha, Simply Safe Dividends, and DividendSensei.com My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams, and enrich their lives. With 22 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams. I'm currently on an epic quest to build a broadly diversified, high-quality, high-yield dividend growth portfolio that: 1. Pays a 5% yield 2. Offers 7% annual dividend growth 3. Pays dividends AT LEAST on a weekly, but preferably, daily basis

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