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.
Source: http://math.yorku.ca/infinity_old/NewMembers/NewMembers.html
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:
| Portfolio balance | 3% | 4% | 5% |
|---|---|---|---|
| $1,000,000 | $30,000 | $40,000 | $50,000 |
| $2,000,000 | $60,000 | $80,000 | $100,000 |
| $3,000,000 | $90,000 | $120,000 | $150,000 |
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.
Wow excellent post, you can tell you spent some serious time on this. A lot of really excellent points, and some things I had never really considered before.
My plan… well… I hope to get out of the rat race by age 50, the earlier the better. Unless of course I have started my own business and I just love growing it. If I own my own business that I love, that I love going to work, that I love growing, that helps people, I can definitely see myself just WANTING to work until about 60 or so. I mean, if it’s what you LOVE to do, why stop?
Hi nice topic. 3% withdrawal is nice and conservative if you can manage it. I’m a bit more conservative and personally prefer a nice chunk in bonds and cash as perservation of capital is very important, particularly as one ages. TIPS are also a good investment to help keep pacement with inflation. Thanks for the mention in the short carnival! (I’m posting on bonds tomorrow!) Best regards, Barb
Kevin,
The consistent thoroughness of your posts and the meat (rather than fluffy material) make you one of the best financial bloggers I have ever read.
This is great stuff. You and I have discussed this material at length, online, and I’m really glad that you articulated it so clearly. This is a wonderfully pedagogical post Kevin.
Andrew
@myfinancialobjectives
I feel the same way. To me, getting out of the rat race/retirement is not the same thing as no longer working. If I could simultaneously get out of the rat race and find a position (or start my own business) where I could find passion and enjoyment, then I know I would be truly happy, indeed.
@Barb
Yep, I agree that 3% is fairly safe and it also imposes some discipline on your spending 🙂 I would like to blend my portfolio and my job; i.e. I don’t see myself just stopping work altogether, but if I can reach a point where my portfolio generates 20% of my net increase in worth, then I’m doing better. If I reach the point where my portfolio accounts for more than 50% of the increase, then I’m nearly out of the rat race. When I reach the point where 3% of my portfolio can replace more than 50% of my current income, then I think I can say that I have reached that point, and I could do things like travel the world for a year to explore and to do volunteer work in other countries, which I couldn’t do now without severe consequences.
@Andrew
You give me too much credit! I can truthfully say though that you are also one of the most honest and refreshing writers that I’ve come across, and I feel that I’ve learned a lot from you and that I’ve grown as a result. If it comes out in posts like these, then it is part due to what I have learned as a result of our discussions and your immense knowledge of finance. Thank you for that!
Really interesting post and good intro to an important subject that is heavily researched today.
For those interested in latest research you may want to check out
http://www.kitces.com/blog/index.php?/archives/29-Is-the-Safe-Withdrawal-Rate-too-safe-Or-too-aggressive!.html
I think it is also necessary to turn the question around and ask whether we can “survive” on 3%/year. Some people might be surprised. For example, estimates range from $150,000 – $250,000, on average, for medical expenses for retirees in the U.S. Most people are unaware that studies show the healthier you are the greater out of pocket medical expenses you will have over the long term because you will live longer.
Thanks for the link, that is an interesting take on it. I believe that for young people today, the whole concept of medical expenses will be turned entirely on its head by the time we get toward that age.
For people already in their 50s and 60s, then the issue is not so cut and dry. I don’t live in the US so I am not completely aware of how things work there, but I feel that that is a crazy amount of money to be spending on medical expenses. Unless you are spending all of your days in the OR, how can the expenses possibly be that high? I’m doubtful that the recent changes to U.S. healthcare will do anything to help out here, either, since they just seem to cartelize the insurance industry even more than it already is.
I’d love to hear your take on this issue though; what are your thoughts?
I think three areas drive it up: prescription drugs, length of retirement, and assisted living. Where I live, assisted living for Alzheimers patients costs approximately $80,000/year with Medicare being no help.
I have always believed in investing with a multi generational time horizon, although not for the same reasons that you talk about. You raise some valid points.
Even assuming that there is no cure for oldness and death during our lifetimes, it always irks me that majority of advisors focus on retirement as a goal for your portfolio and all the asset allocation advice assumes that we would want to consume or atleast stop growing our portfolios as we come closer to death. I choose to consider the wealth I create in my lifetime as a legacy I will leave to my children and grandchildren or even the society at large with philanthropic activities and therefore I would like to see myself as a steward of the family wealth with a fiduciary responsibility to maximize its growth.
That’s an interesting take on it. Those are also perfectly valid reasons to grow a portfolio, and like you, I also don’t understand the emphasis on portfolio consumption once you reach a certain age. I suppose it can be difficult for some people to shift their habits toward less consumption today so that they can enjoy greater consumption in the future, without depleting their store or wealth.
The first thing your advisor should do is talk about your goals. If your goal is to leave an inheritance you would be more aggressively invested than if your goal is to avoid running out of money.
Good point, Robert. I think if one is young, they should aim to leave an inheritance to themselves. Relying on government aid in 30-40 years is not a sure thing, and I think “dying with too much money” is not something we’ll have to worry about with extended lifespans…
Very cool post Kevin, I missed it before.
I would love to get this kind of set up going for myself. Feels like a long way off before I will be able to invest but in the meantime I hope to build enough passive income to also keep stocking my investments in the future and get to a stage like this…. Fingers crossed!
You’re doing very well for yourself… you’ll be there before you know it!
Kevin,
Great post! I am leaning toward rentals as a way to generate income after exiting the rat race. If the rental property contributes positive net worth every month, it will eventually become cash flow positive because rent goes up and the amount of mortgage interest goes down year over year.
positive net worth = rent income – mortgage interest – tax – misc
positive cash flow = rent income – mortgage interest – mortgage principle – tax – misc
Also, like you said exiting the rat race does not mean stop working. If I can find something that I like to do part time and generate minimal income, it will goes a long way to help reduce the withdrawal rate. I want to exit the rat race by 40, but will not draw down the nest egg until 60s.
Hi Joe,
Hope you are getting close to that goal. It’s been a year and a half since that comment, and your blog has grown fantastically in the meanwhile. 🙂
Getting out of the rate race is definitely a motivator for many. Unfortunately more people sit there and think about getting out rather than being proactive and doing something about it.
My multiple income streams have helped me in being able to retire sooner and become financilally independent. I can say that in about 5 years, I will no longer have to rely on a salary to keep me afloat 🙂
Sweet! Congrats on getting there; I believe many young people can do it but it takes a lot of hard work. Financial independence isn’t a prize easily won, but it can be done especially if you save early and save a lot.
Thanks for this post that I consider very appropriate. I think the key is to understand three important ways. A. – The population increasingly living longer. Consequently, our retirement fund must cover each time, the needs of a person for more years. 2. – The government will have fewer resources in the future than today. Accordingly, we will have to cover with our own money, some services that the government currently funds or subsidizes. 3. – As a result of the two strands and a yield of 3 or 4% per year will not be enough to build an adequate retirement fund. All people have to devote more time to our fund, in order to access higher annual returns. Otherwise, we will not cover, not even the annual inflation.
Agreed; time to save more money.
Right now I’m investing through my 401k and haven’t had to draw down on it at all fortunately. It’s growing fairly well since my company has a nice match and I stay diversified. It’s been a rough few weeks in the market lately though so I need to rethink my allocations. Times like these make me appreciate “cash is king.”
One thing I miss about working for a company is the 6% match that we had. They’re no longer so generous with new employees!
I definitely think that more people should give thought to an infinite portfolio. There really is no reason why people shouldn’t plan for longer. People are living longer, there are often family members and/or friends to help, a legacy to leave, and numerous charitable causes that can benefit from your generosity.
Someone might call me out on the fact that resources aren’t infinite, but hey, we can always plan for the future, right? Another benefit to increased savings is that more funds can be channeled toward investment, increasing productive capacity for the future.
I would like to get into rental properties like Joe for income later in life. I would also like to start a few more side hustles so to speak.
I think regardless of when I retire I will always be doing some kind of work. I like to stay active and learn new things. Plus keeping the brain stimulated prevents it from disintegrating.
Definitely — I think we have to keep at least somewhat busy until the end!
This is my ultimate goal. I hope to be able to own a rental property at some point in the future to boost my income streams, but at this point saving for a house for me to live in is the number one priority. Unfortunately, I live in an incredibly expensive area, so my housing options are either buying a very expensive house and only commuting 20-30 minutes to work or buying a slightly cheaper house and commuting an hour or more to work. This is something my boyfriend and I will have to put a lot of thought into over the next few years, and it could make a big difference in how long it will take us to get that infinite portfolio.
Are you in the Vancouver area or similar? Saving up was hard enough for us here in the east; I can’t imagine out west. All I can say is that you don’t want to be in a position where the loss of one income could expose you to bankruptcy.