Billy and Akaisha Kaderli used to own a restaurant. She ran it. He worked at an investment firm. But in 1991, the couple retired. They were just 38 years old. "We sold most of our possessions," Ms. Kaderli said, "including our house and our car." They put their entire proceeds, $500,000 (U.S.), in Vanguard's S&P 500 index.
Mr. Kaderli figured that if they lived in low-cost countries, they could live on 4 per cent of their investment portfolio each year. He hoped the money would last at least as long as they would.
In 2010, Philip Cooley, Carl Hubbard and Daniel Walz published a research paper in the Journal of Financial Planning. They back-tested a variety of portfolio allocations between January, 1926, and December, 2009. They found that if investors withdrew an inflation-adjusted 4 per cent a year, their money stood an excellent chance of lasting 30 years.
If investors chose to withdraw more than 4 per cent, their risk would increase. They might run out of money. Based on the research, those withdrawing an inflation-adjusted 5 per cent a year, from a 100-per-cent stock market portfolio, had a 96-per cent chance that their money would last for three decades. Those odds dropped to 87 per cent if they withdrew 7 per cent.
Many investors set a benchmark during their first year of retirement. If they have $100,000 in an investment portfolio, they would withdraw $4,000 (4 per cent) during their first year of retirement. In their second year of retirement, if inflation were 2 per cent, they would withdraw $4,080 (that's 2 per cent more than $4,000). In the years that followed, they could keep bumping up withdrawals to cover the rising cost of living.
Other investors might prefer something easier. They could simply withdraw 4 per cent of their portfolio's value every year. This could give them a windfall, after a good year for stocks. But it would have the opposite effect in years when stocks drop.
I wanted to see how this would have worked for the $500,000 that the Kaderlis had invested in the S&P 500 in 1991. This year, 2016, marks their 25th year of retirement. I used portfoliovisualizer.com to track their withdrawals and their portfolio value over time. I assumed that they stuck to a 4-per-cent annual withdrawal rate.
Stocks gyrated, which would have affected their year-to-year withdrawals. But over the past 25 years, they would have taken a total of $1.33-million from their initial $500,000 portfolio. Yes, you read that right. They would also have plenty left. By April 30, 2016, despite those annual withdrawals, their portfolio would be valued at $1.86-million.
But the Kaderlis retired halfway through history's greatest bull market. What if a Canadian couple had retired at the start of the so-called Lost Decade? In theory, late 2000 would have been one of the worst times to retire.
The stock index fell five times between 2001 and 2015. In 2001, it dropped 14.3 per cent. It fell another 14 per cent in 2002. In 2008, it went off a cliff, dropping 31.1 per cent. In 2011, it dropped 9.3 per cent and in 2015, it slipped 7.8 per cent.
If a retired Canadian couple had split $500,000 evenly between the first iShares stock and bond market ETFs on December, 2000, what would have happened if they withdrew 4 per cent a year?
Over 16 years, they would have taken a total of $365,549 from their initial $500,000 portfolio. By April 30, 2016, despite the withdrawals, their portfolio would be worth $620,181.
Investment costs, however, could wreak havoc with retirees' savings. Many Canadians pay 2.5 per cent a year in mutual fund fees. Such fees weren't factored into the back-tested study in the Journal of Financial Planning. That's why these investors shouldn't bank on withdrawing 4 per cent a year. If they give up 2.5 per cent to fees, a safe withdrawal rate could be as little as 1.5 per cent.
Suddenly, a retirement portfolio in actively managed funds doesn't look as rosy.