As the largest segment of the nation’s population (78 million baby boomers) looks forward to retirement, one would wonder with a Government so full of debt,  if that could possibly affect our nation’s new retirees. Sadly, about 20 million of those 78 million Americans only have a net worth of $50,000 or less which means that they will be relying heavily on Social Security - a system that is already stressed. In June of 2006, the Center for Retirement Research added more unpleasant news. They estimate that nearly 43% of Americans simply aren’t saving enough to live a comfortable retirement. But what is “comfortable”?

The Center assumes “comfortable” means anywhere between 65%-85% of an individual’s working income. This means if you make $50,000 now, that in retirement you should only need about $32,000-$42,000 per year to live on. So, if Americans are “falling short” of even the modest goal, as The Center’s study suggests, then their incomes will fall below that $32,000 mark. But The Center, admittedly, underestimates the shortfall.

Their prediction of a shortfall assumes that these individuals will be retiring at age 65, cashing in all of their investments and drawing a stream of income using an immediate annuity, and cashing out their home equity for an income stream using a reverse mortgage, and relying on social security, leaving them no savings whatsoever. Also, The Center’s study completely excludes the healthcare “wildcard” - the costs of which will undoubtedly vary from person to person.

If this wasn’t disheartening enough, these retirees (as well and the rest of us) will have to continue to battle a U.S. Dollar that will lose value over the long-run, and fight with the ever annoying effects of inflation. And...on top of it all, even those with a substantial retirement savings may be in for a big, huge, nasty surprise (maybe you should give your favorite rich uncle a call and tell him to come read this next part).

The Perpetual Stock Market That Couldn’t

As the stock market reverts back to its historical averages over the next 10-20 years, your retirement could turn out to be a lot smaller than you originally expected. Or...you could actually run out of money.

Now, there are many reasons why you or someone you care about could run out of money in retirement (reckless investment behavior, having all of your money in the stock market all of the time, trying foolishly to make 100% of your money earn 10-15%, bad withdrawal patterns, and so on), but here is an example of how your dream retirement could turn into a big, fat, nightmare:

Let’s assume the S&P 500 will average 8% in the future. If you had $1 million in savings, you might be thinking that you could safely withdraw $80,000/yr during your retirement years and maintain that income indefinitely (heck, maybe you’d just be happy with the thought of a million dollars!).

But, if you don’t already know, an average return of 8% doesn’t mean that the market is going to return 8% every year. At this point we should probably stop because I can hear someone in the back of the crowd yelling about how their favorite mutual fund is pumping up their portfolio with 25% returns. In addition to actually creating a bigger problem (which I’ll explain below), it just isn’t feasible to expect such a fund to survive long-term.

For starters, many “superstar” funds tend to become very popular with the public who love to chase higher and higher double digit returns, which will grow the fund...which will, in turn, become its own demise.

Once mutual funds hit a certain size, they tend to level off and even decline due to a “flooding” of investors. Of course, this is only one of many problems that plague a mutual fund. The “flooding” of investors doesn’t have to be a problem if you get out of the fund in time, but this pretty much destroys the idea of a sustainable high yield mutual fund, which is supposed to be that it is a long-term investment, not a speculation play. Of course, if a mutual fund closes its doors to new investors at some point, you could end up with a good fund. 

OK, anyway, where were we? Oh yeah,...if you had returns that averaged lower than 8% for the first 10 years while you were withdrawing that $80,000 per year, then you would run a serious risk of running out of money long before the stock market could bring up your average return in later years.

We could use the results of a semi-famous study done by Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz of Trinity University to illustrate this phenomenon. Flip a coin. Tails represents a 10% loss (-10%). Heads represents a 30% gain (+30%). If you start with a $1,000,000 portfolio, and roll alternating heads and tails, you could withdraw $81,700 (8.17% of the initial amount) over the next 30 years before all of your money runs out.

But, if you are one of those unlucky folks and roll 15 straight tails before rolling 15 straight heads, you can only take $18,600 per year. If you reverse the process and roll 15 heads followed by 15 tails, you can withdraw $248,600 per year (obviously a HUGE difference). According to Cooley, Hubbard, and Walz, the success rate of various withdrawal strategies across many historical periods can vary widely. They analyzed these withdrawal strategies and came to a pretty shocking conclusion: only a 4-5% withdraw rate (of the original portfolio balance) is reasonably sustainable over a long period of time.

This is why your financial adviser keeps telling you that if you want to make $50,000 in retirement, that you need to have a savings of at least a million dollars (5% of a million is $50,000)

To show you how all this coin flipping will affect you in your "golden years", think about this for a moment: if you were to lose 30%, and then gain 8%, it could take you anywhere between 7 years (taxable account) to 5 years (tax deferred account) recover your losses! For example:

$ 500,000 Portfolio
$-150,000 (30% Loss)
____________________

$ 350,000 Balance

A consistent, year over year, 8% return (even in a tax deferred account) will take 5 years just to break the $500,000 mark to get you even again. And, this is compounding every cent you earn without spending a dime (which is hard to do if you are already retired isn’t it?). Now, don’t forget that if you want to try to average 25% gains in a stock or mutual fund over the long-term, then there’s a HUGE probability that we are going to take on a lot more risk than if we were investing in, say, Treasury bonds. So, while our losses could be 10%, they could also be 30%, 40%, or more. The swings would likely be much larger, and isn't that going to affect your final outcome?

I’ll be the first to admit that there’s probably more to worry about in retirement than how much money a particular stock or mutual fund made last year (seeing as if you are completely retired then you aren’t drawing in a paycheck from a job to replenish your losses). Isn’t how much money you have to spend at least as important as how much you can potentially make in the stock market? You start saving money for retirement so that you have something to spend, not so that you have a balance sheet with a lot of numbers on it to sit and stare at.

All of this brings up some interesting questions. Can you plan for your retirement focusing only on accumulation? Should you consider a lower potential rate of return throughout your investment lifetime in exchange for consistency in income later on? Does "aggressive growth" really a valid concept in investing? What about "aggressive growth and aggressive loss"?