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Archive for the ‘Investing for Retirement’

Maximum Withdrawal Rate in Retirement

August 19, 2010 By: Grey Fox Category: Investing for Retirement No Comments →

One of the key decisions a retiree must make is how much to withdrawal each year. When faced with this decision, it would be helpful to know the maximum amount that can be taken each year without running out of money.

Well, the good news is that there is an exact formula for the Maximum Withdrawal Rate. All you need to know is the annual total annual real return for each year of the withdrawal period. The bad news is that the future annual returns for most investments are not known.

Maximum Withdrawal Rate (MWR) Defined
DThe Maximum Withdrawal Rate is the initial rate of withdrawal that depletes the portfolio balance to zero at the end of the period. The first year’s withdrawal start at the MWR and are increased each year with inflation to maintain constant real consumption. The process is similar to a 30-year fixed mortgage payment calculation, except that the rate is not fixed.

If your withdrawal rate is greater than the MWR,  there will be a shortage at the end. In other words, you will run out of money prematurely. If your withdrawal rate is less the the MWR, there will be a surplus at the end.

The Magic Sum
The formula to calculate the MWR makes use of a magic sum. This sum is a remarkable figure that turns up in many calculations. The magic sum needs two things: all the annual inflation rates and all the annual returns. Here the terms used in the magic sum are defined:

  • i is an annual Inflation Rate. (Example: if inflation is 3%, then i = 0.03)
  • I = 1 + i is an Inflation Factor. (Example: 1.03)
  • r an Annual Return for the portfolio. (Example: Annual Return is 8.9% so r = 0.089)
  • g = 1 + r is the corresponding Gain Factor. (Example: g=1.089 means a $1.00 investment grows to $1.089 over the year)
  • For years 1, 2, 3, … up to year N, we’ll call the inflation rates
    i1, i2, … iN and similarly for the Annual Returns and Factors etc.
  • Gn is the cumulative Gain Factor over n successive years, so Gn is the product of a bunch of annual Gain Factors, like: Gn = g1g2g3gn

Finally, here is the formula for calculating the Magic Sum:

the N-year MagicSumI1/G1 + I2/G2I3/G3 + … + IN/GN

Formula from Magic Sum on gummy-stuff.org

Then the MWR is simply the inverse of the Magic Sum:

MWR = 1/MagicSum = 1/(I1/G1 + I2/G2I3/G3 + … + IN/GN)

From Sensible Withdrawal Rates article on gummy-stuff.org

This formula is not as bad as it looks and is actually easy to program into an Excel spreadsheet. You can see how the MWR only depends on the total annual returns and the annual inflation rates.

[Notice that whether or not the returns come from dividends, interest or capital gains is irrelevant to calculating the maximum withdrawal rate. See previous article titled Eating Seed Corn.]

What Can be Learned From This Equation
First of all notice that there is a term for each year. So with each additional year another term is added and the sum is larger larger. Since the MWR is the inverse, the inference is that the MWR goes down with more years.

Second notice that the first year’s return is in every sum. The last year’s return is only in the last sum. We can infer that the early years have the most weight and are the most important. Further out years become less important.

So What Good Is It?
As mentioned at the top, each annual return must be known to calculate the MWR. We know this for past years, so we can calculate historical MWR for various portfolios.

This has some utility for comparing how various portfolios fared in past markets. For instance, we can see how various mixes of stocks and bonds would have served in the past. We may also be able to draw some general conclusions about constructing retirement portfolios by looking at MWR’s over past periods.

Back To The Future
We are still left with our original problem, which is how much to start withdrawing today? Future returns are unknown so you can’t just use this formual directly to find the maximum withdrawal rate. However, it is possible to play “What If?” and generate possible future scenarios. For instance, annual returns can be generated from a probability distribution and the MWR calculated for some hypothetical sequence of returns.

I’m going to be using the formula in future articles to compare various portfolios and withdrawal strategies.

Where To Park Short-Term Cash

August 13, 2010 By: Grey Fox Category: Investing for Retirement No Comments →

The author concludes that best place short-term cash at this time is…

Eating Seed Corn

August 10, 2010 By: Grey Fox Category: Investing for Retirement No Comments →

A big question for retirees is how to create cash flow from your retirement nest egg. There is a debate among retirees whether it is better to collect dividends or sell shares. Financial writers sometimes characterize this dichotomy as being either an “income investor” or a “total-return investor”.
An argument for dividends is you don’t have [...]

Investing In a Low-Return World

June 14, 2010 By: Grey Fox Category: Investing for Retirement Comments Off

Investors have no where to hide in the low-return world we are living in today.

How Much Can I Spend Each Year In Retirement?

June 09, 2010 By: Grey Fox Category: Investing for Retirement No Comments →

In a previous article, I looked at the question, “How Much Do I Need To Retire?” In that article, we estimated an annual budget, determined how much would be covered by income from things like social security, pensions and immediate annuities. Then we used the 4% rule to estimate the required size of your nest [...]

How Much is Needed To Retire?

May 20, 2010 By: Grey Fox Category: Investing for Retirement No Comments →

You worked hard all your life at your job. Maybe you worked in an air-conditioned office or maybe you worked in a coal mine. It doesn’t matter, you served your time, and some day you will no longer be able to go to work every day.
Fortunately, you were a disciplined saver and investor, and you [...]

Betting Against The American Dream

April 18, 2010 By: Grey Fox Category: Investing for Retirement No Comments →

How Wall Street Bankers helped hedge funds bet against the American Dream and brought down the U.S. economy.

Sources of Return for Gold, Stock and Bonds

April 16, 2010 By: Grey Fox Category: Investing for Retirement No Comments →

There is a lot of confusion and misinformation in the financial press about various kinds of investments. The source of return is not the same for every investment. What is good for one investment may not be good for another investment. I’ll look at three: Gold, Stocks and Bonds.
Gold
Returns from gold are simple to understand. [...]

How Much To Save?

April 10, 2010 By: Grey Fox Category: Investing for Retirement No Comments →

Grayfox looks at how much to save for versus the investment return needed to retire.

Critical Mass in Retirement

April 04, 2010 By: Grey Fox Category: Investing for Retirement No Comments →

By consuming less and saving more, your retirement portfolio can reach critical mass.

Stock, Bond and Balanced Mutual Funds

February 21, 2010 By: Max Smart Category: Investing for Retirement No Comments →

In the last article, Diversification Through Mutual Funds, I wrote about investing in the stock market using mutual funds. I described two kinds of mutual funds: active funds and passive funds.
Based on the kinds of securities that are held, there are three main categories of mutual funds:

Stock Mutual Funds, which invest only in stocks
[...]

Diversification Through Mutual Funds

February 06, 2010 By: Max Smart Category: Investing for Retirement Comments Off

Where we left off in the last article, Where To Invest Your IRA Contribution, we assumed you have $5000 sitting in a money market fund while you decide how to split the money between stocks and bonds. In that article, I wrote about asset allocation, which means dividing your money between stocks and bonds. This [...]

Harry Markowitz and the Tale of the Novice Monk

February 03, 2010 By: Grey Fox Category: Investing for Retirement Comments Off

Many prudent investors follow a “buy and hold” investing strategy. They eschew market timing, i.e. buying and selling based on fundamental analysis, valuation, technical analysis, chart reading or the macro economy. After all, no one has the ability to predict the future, at least not well enough to consistently make above average return.
And the “stay [...]

Where to Invest Your IRA Contribution

January 23, 2010 By: Max Smart Category: Investing for Retirement Comments Off

In the previous article, I explained How to Start Investing with an IRA. That article covered which kind of IRA to open (Roth IRA), where to go for your IRA (Fidelity, Schwab or Vanguard) and how to fund your IRA (from your checking account by electronic funds transfer), and where to park your money (money [...]

Was It Really a Lost Decade for Investors?

January 21, 2010 By: Grey Fox Category: Investing for Retirement Comments Off

A lot has been written about the so-called lost decade for stocks including this previous article, Lost Decade for Stock Investors. But was it really a lost decade investors? There has been some debate about this. Some pundits have argued that it has not been a lost decade for investors.**
What Would Be a Lost Decade?
First, [...]

How to Start Investing with an IRA

January 19, 2010 By: Max Smart Category: Investing for Retirement Comments Off

In a previous article, I wrote about Saving & Investing for Retirement. In that article, I wrote that the three investing accounts you need were a 401(k) plan, an IRA and a taxable account. Like the three legs of a stool.
Your 401(k) is handled at your place of employment. Human Resources gives you all [...]

The Lost Decade for Stock Investors

January 11, 2010 By: Grey Fox Category: Investing for Retirement Comments Off

There is something important that is being discussed in the financial press at this time. The year 2010 began about a week ago, which brings to a close the first decade of the 21st century. So people are tallying up the results for this past decade. And the results aren’t looking all that great.
The Lost [...]

What is Saving & Investment?

January 07, 2010 By: Max Smart Category: Investing for Retirement 1 Comment →

I once saw a bit of graffiti written on a wall that said “Jesus Saves.” Underneath it, some wag had scrawled “Moses Invests.”
What is saving? What is investing? Saving is when you spend less than you earn. Investing is how you take your savings and grow it. Saving and Investment go hand-in-hand. Without saving, there [...]

Saving & Investing for Retirement

January 05, 2010 By: Max Smart Category: Investing for Retirement Comments Off

In another article I wrote about the importance of saving. Some of the things we talked about saving for was to build an emergency fund, to buy a new car, and for the down payment on a house. The only thing that I deferred discussing was saving for retirement. Here is that discussion.
Good-bye Company Pension, [...]