Estimating your retirement nest egg

For most Americans, retirement planning is ultimately focused on accumulating a “nest egg” of savings and investments to generate enough income to pay for a comfortable lifestyle.

To find out how large a nest egg you will need you must first estimate your “retirement income gap”. This is the difference between how much you’ll need each year to enjoy the lifestyle that you want and the amount of income that you expect to receive from sources including Social Security, employer pensions and part-time work. This gap will need to be filled from your personal savings and investments.

For example, using today’s dollars, let’s say you plan to retire at age 66 and determine you need $75,000 per year (before taxes) to enjoy a comfortable retirement. If you only receive $25,000 in income from Social Security, your investment portfolio will have to generate $50,000 every year after inflation for as long as you live. Using Social Security as the only income source simplifies the calculation because the benefits are automatically adjusted each year for inflation.

So how large a portfolio is necessary to generate $50,000 annually in inflation-adjusted dollars for as long as you live? Since running out of money is the number one concern for most retirees, much attention has been focused on this subject. The research has been directed specifically toward determining a “sustainable portfolio withdrawal rate”. This is the maximum amount that can be withdrawn from your retirement assets each year with reasonable confidence that the portfolio will provide a lasting income. Once you arrive at a withdrawal rate you are comfortable with, you can estimate the size of the portfolio required.

In 1994, Bill Bengen (a California financial planner) conducted a seminal study. His research suggested that based upon historical (1926-1975) inflation rates and investment returns, a retiree’s portfolio consisting of approximately 60 percent stocks and 40 percent bonds should, with a reasonably high probability, last for approximately 30 years. This was possible if an investor initially withdrew no more than 4 percent of the portfolio balance, and continued withdrawing that same inflation-adjusted dollar amount each year. Using this 4 percent guideline, if you determined that your retirement income gap was $50,000, you would need a portfolio of approximately $1,250,000 ($50,000 divided by .04) at the beginning of your retirement to fill that gap.

A caveat is in order here. While the 4 percent guideline can provide future retirees a target to shoot for, it is dependent upon several variables that differ from person to person and are impossible to predict with any accuracy. The best you can do is to make reasonable and conservative assumptions regarding how long you plan to live in retirement, what investment returns you expect to earn from your portfolio during retirement and what you expect inflation to be.

For those who want a high degree of confidence that they will not run out of money, it makes sense to be conservative about your future assumptions. Therefore, if you expect retirement to last longer than 30 years, or project future investment returns to be lower than historical returns, or anticipate future inflation to be higher than historical inflation, you should reduce your portfolio withdrawal rate below 4 percent. This means you will need a larger portfolio at retirement. Remember, the higher the withdrawal rate, the greater the chance the portfolio will not last as long as you need it to.

Striking the right balance with asset allocation

Harry Markowitz, Nobel laureate in economics and a pioneer in investment theory suggested that a fundamental responsibility of any investor is to manage the risk of their portfolio. The risk he was referring to is volatility: the ups and downs of stock prices during the year and from year to year. Investors who ignore risk in pursuit of returns expose themselves to intolerable portfolio declines prompting them to abandon their plan thereby converting temporary losses into permanent ones. Conversely, those who choose to minimize or avoid volatility entirely must be willing to accept returns that may prove insufficient to fund their future goals.

The world’s capital markets are comprised of different asset classes each with their own risk and return characteristics. The three major categories are stocks, bonds and cash. A portfolio’s distribution across asset classes refers to its asset allocation. Sophisticated investors have known for decades that asset allocation is the most significant determinant of a portfolio’s performance. Landmark studies published in the 1980s and 1990s analyzed the returns of large institutional plans and confirmed the crucial role of asset allocation estimating that it explains more than 90% of a portfolio’s returns and volatility over time. The message for all investors is that asset allocation is far and away the most important part of designing a successful portfolio.

In general, stocks provide the growth engine for the portfolio. The higher the allocation to stocks the higher the expected investment returns and along with it the greater the volatility. Bonds, on the other hand, offer stability, but not much long-term growth potential especially after accounting for inflation.

The appropriate mix of stocks and bonds will strike a comfortable balance between growth and stability and reflect the individual investor’s financial goals and ability to handle risk. Investing is often framed as a choice between eating well as a result of high stock market returns and sleeping well from the stability that bonds provide. The implication is that investors must choose one or the other. Markowitz showed us that a sensible asset allocation allows us to do both.

Are you getting compensated for investment risk?

While there are various types of investment risk, the proxy most often used by investment professionals is a statistical measure known as standard deviation. In basic terms, standard deviation indicates how volatile and unreliable the returns of an investment can be. The more volatile the expected returns, the higher the standard deviation and risk because the chance of experiencing a large loss on the investment is greater. For these reasons bank savings accounts, high-quality bonds and stocks have low, moderate and high standard deviations respectively. Because risk and return are correlated, we can expect (but are not assured of) higher returns from stocks than bonds and higher returns from bonds than savings accounts.

In 1952 Harry Markowitz, a Nobel laureate in economics and a pioneer in the area of finance known as Modern Portfolio Theory (MPT), proposed that both math and common sense suggest that investors should consider both risk and return when making investment decisions. Furthermore, because investors are risk averse, they should demand suitable compensation for taking on risk. A rational person, therefore, will only invest in riskier securities if they believe that the expected returns on those securities will be high enough to warrant taking on the risk. Otherwise, a prudent investor would choose less risky but equally profitable alternatives.

There are two central and related tenets of MPT that have important implications for the everyday investor. First, by mixing different types of stocks that move up and down independently of each other, investors can reduce the volatility of their overall portfolio. This is known as diversification. Markowitz further demonstrated that while diversification reduces portfolio risk it does so while maintaining and potentially enhancing returns. This is why diversification is considered the one “free lunch” in finance. Second, because risk reduction through diversification can be easily achieved, the financial markets do not reward investors who fail to diversify their holdings. The result is what many investment theorists refer to as uncompensated risk.

Risk and return go hand in hand. However, for stock investments, this relationship only holds true once they have been effectively diversified.  Empirical research has shown that as investors move across the spectrum from broadly diversified portfolios to those consisting of concentrated positions they become increasingly exposed to uncompensated risk. In other words, there is additional risk for which they do not receive a commensurate return. At the extreme, some investors may hold a highly concentrated position in a single company stock, but more typical are those whose financial assets are skewed toward a small group of sector funds.

Sector funds are those that invest in a narrow slice of the market such as an industry like biotech or banking or a specific region of the world such as China or Brazil.  They are diversified within an industry or geographic region but still expose the investor to unnecessary concentration and uncompensated risk. The explosion in niche exchange traded funds (ETFs) has attracted legions of investors who believe they possess superior insight into certain sectors.

There is no such thing as risk-free returns when it comes to investing. Those seeking to avoid risk will also avoid potential returns. Markowitz taught us that smart stock market investors focus on controlling risk, not avoiding it. The most effective way to accomplish this is by building a broadly-diversified portfolio rather than placing a big bet on a particular stock, industry or country. Once the unnecessary risk has been wrung out of the stock portfolio, the only one that remains is the risk inherent in investing in the market itself. This risk is unavoidable and for most investors will be challenging enough to handle.