How long will $500,000 last in retirement? The answer is… it depends. You’ll need to start with some basic retirement questions. To a large degree, your ability to retire on $500,000 will depend on your answers:
- How old are you and how long do you want to plan on funding your retirement?
- How much will you spend in retirement?
- What are your other sources of income?
- Will you receive an inheritance or other sources of assets?
- Do you own your $500,000 in pre-tax or after-tax accounts?
And finally, what is your investment risk tolerance?
This last question is a particularly interesting one, because the (surprising) answer is it doesn’t matter as much as you might think. Let me explain: There is a large body of research centered on how much you can withdraw from a portfolio without running out of money. Prior to the 1990s, researchers used the average returns and volatility of stocks and bonds at the time to conclude that the safe withdrawal rate was 6%-7% each year. Using the 7% withdrawal rate, your $500,000 could reliably pay you $35,000 annually, or a little over $2,900 per month. This approach came to the intuitive answer that the higher returns you get from your portfolio, the more money you could withdraw to fund your retirement.
The Change In Safe Withdrawal Rates
That changed in the 1990s when withdrawal rate studies used a slightly different methodology. Instead of just looking at the impact of portfolio returns, researchers wanted to know the impact of portfolio volatility on safe withdrawal rates. Where prior studies used the average returns and volatility of stocks and bonds, they used actual historical sequences of returns of stocks and bonds over different time periods. As a result, retirement ‘common sense’ changed in a flash, because the earlier assumption that taking more risk and earning higher returns would reward you with higher safe withdrawal rates was disproved. It turned out that constructing riskier portfolios resulted in lower withdrawal rates, because portfolios ran out of money during market crashes or long-term bear markets. Constructing lower risk portfolios with lower allocations to stocks and higher allocations to bonds resulted in similar results when inflation was raging in the 1970’s and bond returns were sharply lower.
The ‘sweet spot’ in the early studies was a portfolio constructed of 60% stocks and 40% bonds—the well-known 60/40 portfolio. If you are not especially risk tolerant (meaning you lose sleep when the stock market goes into one of its periodic meltdowns), then the bad news is that the average decline of a 60/40 portfolio in a bear market using data from 1970 to the present is about 25%. In an average bear market, your $500,000 portfolio would suffer paper losses of $125,000, reducing the value at the market bottom to only $375,000.
That’s the good news.
The bad news is that these declines in portfolio value are made worse by the withdrawals you would be taking to fund your retirement.
The Real Risk To A $500,000 Retirement
Even if you can tolerate what most investors identify as the moderate risk of a 60/40 allocation, the peril to your retirement is all about taking withdrawals from the portfolio in a bear market in either stocks or bonds. If you are not withdrawing from your portfolio, you can patiently wait for the stock market to recover from bear market declines. The problem is that although bear markets are typically followed by above average bull market returns, when you consider portfolio withdrawals in addition to market declines, you simply don’t have enough capital left to benefit from the higher returns that follow the bear market. It may be counterintuitive, but you don’t have to take more risk to maximize your ability to retire on $500,000. The research tells us that anything more than a 60% allocation to a well-diversified stock portfolio just doesn’t help.
The average safe withdrawal rate (safe meaning there was no historical scenario when you run of money) from the portfolio based on original studies was 4%. Later research showed that if you properly diversified your portfolio by owning more than just U.S. stocks and U.S. bonds, the safe withdrawal rate increases to the 4.5% to 5% range. Put differently, your $500,000 can safely pay you up to $25,000 annually (or $2,083 per month), adjusted for inflation, for the rest of your life.
Invest With Less Volatility
But what if you could invest your portfolio so that you received returns similar to historical market returns, but you did so with less risk or volatility? To get the answer, I asked our Director of Planning Research and acknowledged expert on safe withdrawal rates, Michael Kitces. He writes, “If you can do 60/40 returns with lower risk, you would be able to sustain higher withdrawal rates (you’d close the gap between the 6.5% average withdrawal rate and the 4% “safe” withdrawal rate that defends against bad return sequences.)”
So how can you gather market returns in a diversified portfolio with less risk than market history suggests? Unfortunately the planning industry tells us we can’t. They say you are doomed to gather the average returns and volatility of financial markets in the future. However, at Pinnacle Advisory Group, we utilize active management techniques that allow us to change portfolio asset allocation in dangerous markets. As a result, we offer clients the possibility of earning market returns with less than market volatility… and consequently offer the possibility of driving higher withdrawal rates from client portfolios.
Of course, we have a full-time team of portfolio analysts to implement our risk management techniques. If you are a “do-it-yourselfer,” I typically recommend that you stick to a properly diversified 60/40 portfolio and take your 4.5%-5% withdrawals. All you have to do is rebalance your account annually and make sure you don’t overspend in any particular year.
