This is the fourth and final post in a series of articles on living to 100 and beyond. This post was originally published on June 12, 2010.
Traditional retirement planning is made with one main assumption in mind: after you retire, you will only live a couple of decades at most, and you will be drawing down on your retirement portfolio during those years. By the time you die, there might just be enough left to pay for your funeral and pass on something to the kids!
In today’s post, I’m going to be talking about another type of retirement: The infinite portfolio. Now, your portfolio will never actually reach infinity, of course, but I want you to start getting into the mindset that the only direction your portfolio should be moving in the long term, is up.
The first question you might be asking is “Well, if I am going to die at some point, what use is all of this money to me? Why don’t I simply spend it all now, so I can at least enjoy my life before I pass away!” Well, if we were talking about the 20th century or any other century in the past, I might be inclined to agree with you. In centuries past, a lifetime of hard work was usually followed by a late retirement or no retirement, at an age where good health and physical endurance were already quickly fading away. Like you, I don’t see much value in building up wealth and savings if it is not used to improve your quality of life.
This century, however, is different from all the centuries that have come before it. For the first time in the history of our world, our species has developed technology to the point where we will be entering a future of unparalled abundance and magical ability. For the first time ever, we will reach a point where our genetic code is no longer master over our potential, as we will have the ability to modify it at will. Old age will no longer be seen as an inevitable process, but will be recognized for the debilitating disease that it is. As Arthur C. Clarke once said, “Any sufficiently advanced technology is indistinguishable from magic.”
Don’t believe me? Think I’m nothing but a dreamer? Well, that’s what people said about the Wright Brothers. In fact, I think the coming changes will be even harder to comprehend than were the changes of the past century; although we can predict and foresee what technologies are coming down the pipeline, we cannot fully predict their consequences. It is like someone in 1900 trying to imagine what the world would look like 50 years hence, with nuclear technology, and widespread use of automobiles, planes, television, and radio, and with space travel not far away. What a time of change, that was!
The point I’m trying to make is that we really can’t predict what the future is going to bring, but there are a lot of reasons to be optimistic, and thus there are many reasons to plan your portfolio with an infinite time horizon; it should always be growing, and you should never withdraw from it simply to consume and extinguish what you have withdrawn.
I talk more about this in these posts in this series:
Getting out of the rat race
“Getting out of the rat race”. These words are often said, but what do they mean? To me, getting out of the rat race and retirement are synonymous. When you have reached the point where you are no longer required to work for a company for wages in order to support your standard of living, then you have broken free of the rat race. You are no longer locked up in a cage, forced to keep the wheels turning; you are now free to follow your own pursuits, and to go wherever your passions drive you.
Both your income and your levels of expenses play a very big part in determining when you can break free of the rat race. If you make an average income, but your home is paid off and you drive a used car, then you could possibly break free by your 30s or 40s. If you make an average income, but switch cars every 4 years and own a large,expensive home with a big mortgage on it… then good luck to you!
Why get out of the rat race? I have a few reasons:
- You have the freedom to work in a field that truly interests you, with the money earned being less of a concern.
- You have the freedom to do volunteer work abroad, helping others.
- As you are no longer tied to your job, you end the master-slave relationship and become a free agent.
Now, I have not yet broken free of the rat race, but I don’t consider myself a slave in the traditional sense by any means. What I mean here by “slave” is the voluntary servitude that we all put ourselves in by our desire to own land, drive decent cars, have the money to travel and take vacations, and, of course, build up our nest egg. Most of us need to pass through this phase before we can move on to greater financial independence.
In my previous post, I talked about techniques to build the portfolio. Now, I want to talk about making the portfolio infinite.
Building an infinite portfolio
An infinite portfolio, you say? Surely that can’t be possible. Well, since our lifespans will be more or less undeterminable, since there will no longer be “natural” deaths, so the same concept should also apply to our portfolio.
During your working years, your portfolio will be setup like a self-perpetuating machine: What goes out feeds right back in, helping the portfolio to grow. Once you’ve partially or completely exited the rat race, you will need to divert a portion of this stream in order to support your current cash-flow needs. To have an infinite portfolio, the amount diverted should be small enough so that the portfolio continues to grow and continues to have an indefinite lifespan, the same as you.
There are then two primary questions we need to ask:
- How much of the portfolio should I withdraw per year?
- 3%? 4%? 5%?
- How much of my portfolio should be invested in stocks versus bonds?
Here is what the withdrawals would look like, at different portfolio levels and rates:
There has been much research directed into these two questions, and I would like you to go and take a look at “Determining Withdrawal Rates Using Historical Data”, by William P. Bengen. A big thank you goes out to Andrew Hallam for sending me this article.
I highly recommend you take a look at the article, but I’ll go over the main points below, as well as my take on them.
How much of my portfolio should I withdraw per year?
So, how much should you divert from your portfolio each year? First, you need to make sure you leave some room for growth. Your portfolio will need to grow at least 3% per year to compensate for inflation. Therefore, if you are withdrawing 5% per year, then your portfolio will need to grow at least 8% per year in order to keep up with inflation. If you plan on withdrawing from a registered retirement portfolio, then you may need to watch out for the consequences of an IRA withdrawal.
The second main consideration is that your portfolio needs to be able to survive market shocks and crises. Could your portfolio survive a great depression without being extinguished?
In the article, the author performed a historical analysis for each year starting in 1926, and looked at how long a retirement portfolio would last at the different withdrawal rates. For this analysis, the retiree’s portfolio was split 50/50 between stocks and bonds.
Here are the results:
3% withdrawal rate: The portfolio was able to last at least 50 years, even through the great depression!
4% withdrawal rate: Still good, but you can see damage done to the retirees whom retired through the great depression or the bear years of the 70s. We are no longer looking at an infinite portfolio, here.
5% withdrawal rate: This is much worse than 4%. The portfolio is no longer infinite across most of the years.
A 3% withdrawal rate was the only withdrawal rate that was able to survive all of the crises of the past 80 years or so, including the bear years of the 70s and the great depression. Keep in mind these analyses consider only your portfolio; if you continue to generate income through side work or via your own businesses, then there is less of a need to draw on your portfolio, and you can lower your withdrawal rate to even lower than 3% if you wish.
How much should I allocate between stocks and bonds?
Here, the trade-off is between short-term variability and long-term performance. With a higher stock allocation, you open yourself up to larger short-term swings that can devastate the value of your portfolio. However, you can also build up a larger portfolio overall with a higher stock allocation.
The traditional logic here is that your bonds % should match your age, but I feel that is far too safe given that we are no longer interested in consuming our entire portfolio, therefore short-term priorities such as “preserving the capital” are no longer as important.
One interesting conclusion that I draw from the data as presented by the author is that even with a 100% stock portfolio, the portfolio still survived at least 50 years across all the possible retirement dates, with a 3% withdrawal rate.
The author also compared total portfolio size after 20 years of retirement, and the second interesting conclusion that I can see here is that when we move from a low stock allocation to a high stock allocation, the lows get a little bit lower through the worst years, but the highs get much, much higher during the good years. When combined with a low withdrawal rate, stocks appear to be the way to go.
Beating the market with bonds
Now, stocks offer the best long-term performance, but this doesn’t mean that bonds don’t have their place. The author talks about “black hole events”, which represent stock market crashes. For someone who retires before such an event, their retirement is not likely to be all-too pleasant.
However, let’s say that you have a deep portfolio in stocks, but keep 25% in bonds. After the crash, you don’t stick with your 75/25 allocation ratio, but you go all-in stocks. This way, you sell your now relatively-high bonds to buy cheap stocks, which can potentially increase your long-term returns beyond what a simple split would have returned. Andrew Hallam calls this “beating the market with bonds“, and it can help you increase your returns over time. I think a comparison needs to be done to see if it beats a 100% stock allocation over the long run, but this strategy certainly does beat sticking with a fixed stock/bond ratio even through a crash.
Investing it wisely
My personal recommendation is to keep the withdrawal rates low, at 3% maximum, and to lower them after a crash if you can afford it. At a 3% withdrawal rate and a 8% to 10% overall portfolio return, you are looking at a pay raise of 5% to 7% per year. That is not too shabby!
Since we are looking at the long term, a high stock allocation will give a higher total performance, but you can also smooth out the bumps by building up a side portfolio of bonds during the good years, and dumping the bonds back into the stock markets after a crash.
So, reader, what is your approach to an infinite portfolio? What do you think about retirement and exiting the rat race, and what does it mean for you? I am always looking forward to reading your comments.
Short Yakezie Carnival
- Barbara Friedberg Personal Finance: MAKE MORE MONEY, HAVE MORE TIME, & FEEL AMAZING: Part 2
- Deliver Away Debt: The Mega Money Tip List – 600 Money Saving Tips
- Eliminate the Muda! – Early Retirement Extreme – Jacob’s Story
This post was originally published on June 12, 2010.