Averages Will Mislead You

If the average rate of return on your investments is 5%, that says nothing about your getting 5% every year.  There may no year that earns 5%, even approximately.  People approaching retirement with personal assets to support lifestyle must be aware.  You cannot live on averages, only actual.

If someone were to guarantee that you could average 5% on your $1,000,000 fund, over your 30-year retirement, does that mean that you could withdraw $50,000 every year and all would be well?  If you think “Yes” you are vulnerable to a catastrophe.

It is a question of what is your “Safe Withdrawal” rate.  The withdrawal rate such that at least some of the fund will exist at the end of your life.

You could look up the Trinity study which was published in 1998.  It determined that the safe withdrawal rate is 3% to 4% plus inflation and they back checked their idea with data from stock and bond market for 1925 to 1995.  It was updated in 2009 and the same general results were apparent.  Both assumed tax to be paid from the 4% withdrawal.

Their criteria are quite limited.  If you outlive your portfolio, it failed.  If it outlived you, success.  Taxes were not a consideration. 

That is a little sterile for the real world:

  1. Most people will adjust along the way
  2. Taxes matter.  In Canada, emphasize your Tax Free Savings Account.
  3. If you choose a fixed withdrawal, the order of the achieved yield matters.
  4. RRSPs and other tax governed plans have minimum withdrawals higher than the safe withdrawal rate.

Eventually it comes down to establishing your preferred spending and understanding where it will come from.  For people with only their savings to rely upon, the problem of the order of the returns matters.  More than they think.

Suppose someone retires at the end of 2001 with $1,000,000 in their portfolio which is invested entirely in the S&P500 Total Return Index.  Being conservative, they withdraw $40,000 each year.   At the end of December 2015, less than $300,000 remains, even though the index was up more than 6% per year on average. More than 8% for the last 13 years.

Their co-worker retires exactly one year later and invests in exactly the same way.  They also draw $40,000.  Their fund at the end of 2015 is just under $2,000,000.  Their average return is a bit over 8%

Why the difference?  Both averaged well over 4% annually.  The extra $40,000 the first person drew is not the difference.  They both earned the same rate after 2001. The difference is person one lost 30% in the first year of retirement. The capital lost and the income it could have earned is what matters. They both earned the same rate of return after the first year but person one cannot catch up because they had much less money invested at the beginning of 2002.

The moral:  Never trust an average return, no matter how conservative you think it is. Success involves adjusting.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  don@moneyfyi.com  866-285-7772

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