Editor’s note: Seeking Alpha is proud to welcome Baker Street Investor as a new contributor. It’s easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA Premium. Click here to find out more »
The purpose of this article is to share modeling results of various approaches for withdrawing money during retirement, specifically using the bucket method. I ran various simulations with different inputs and measured overall success. This modeling has helped me understand withdrawal approaches during retirement.
Background
I’m in my mid-forties and I’m right in the middle of my career: I’ve been working for 20 years, and I’ll probably continue to work for another 20. I’ve done a decent job saving for retirement, but one of the key questions I struggle to answer is “How much retirement savings is enough?”
During the first 20 years of saving for retirement, my allocation approach has been very simple: I’ve put 100% in stocks. As I’ve considered retirement I struggle to think about how to manage funds that are spread across stocks, bonds and cash. I’ve seen various numbers recommended for allocating between stocks and bonds, but I wanted to be able to model different allocations and see the results for myself.
Over the years, I’ve used various calculators and various rules of thumb for retirement. Inevitably these approaches assume a constant rate of return. However, based on historical returns, I know that the smooth curves I see in these future projections are not realistic. Here’s a typical projection of saving for retirement and spending after retirement. Note the smooth exponential growth up to retirement and the gentle shift into spending.
Source: marketwatch.com
Compare the graphic above to historical S&P valuation over the long term. This time period has many ups and downs complete with long-term cyclical bear and bull markets. Real life is nowhere near as smooth as consistent as the plot above.
Source: mactrotrends.net
I struggled to understand how a retiree would deal with these swings in the market. How can a retiree withdraw money today, and stay confident that she will have money 35+ years from now? What if the market takes a down turn – should she drastically change her approach?
To help me answer these questions and others, I worked to create a simple model of retirement and retirement returns over a 40 year period. I wanted to create a plan that I could follow in good times and bad. I wanted simple rules and guard-rails to follow that would create a conservative approach for retirement withdrawals. I wanted to be able to understand better some historical “worst case” realities to develop a plan with a margin of safety.
With those questions in mind, I set out to create a simple model of potential methods for withdrawals from a retirement nest egg. In my day job, I work to analyze datasets and model potential future outcomes. I used that same approach to model various possibilities for retirement.
Historical data
To look forward I spent a lot of time looking back. I found an excellent set of historical data here.
This dataset spans from 1928 to 2019 and includes the annual inflation adjusted returns for stocks and bonds — based on the historical S&P 500 return and Baa rated corporate bonds. I analyzed this data to better understand what we can learn from history. In my modeling, I use the historical rates of return to test out various potential withdrawal strategies. I’ll share summary findings of the modeling below.
A note on past performance: Yes, I agree: “past performance is no guarantee of future returns”. While nobody knows exactly what the future holds, there are many different scenarios reflected in this 91 year set of historical data. We can select 40 year periods where returns are fantastic – we can equally consider what it would have been like to begin retirement in 1929 – just at the onset of the great depression. This dataset is a perfect proving ground to test out various concepts.
So, here’s what the data looks like. If we started with $100 invested in stocks 1928, we’d have $33,967 at the end of 2019 (adjusted for inflation). By comparison, that same $100 invested in bonds would have yielded only $3,289 (adjusted for inflation).
Source: created by author from historical return data
If we look at the same data on a logarithmic scale – something interesting becomes apparent. If you put equal amounts in stocks and bonds at the beginning of 1928 your bond portfolio would have had a higher balance from 1931 to 1951!
Source: created by author from historical return data
Here’s a view that shows the annual returns in chronological order. This graphic shows the annual return (adjusted for inflation) for both stocks and bonds. Note that there are some years with wonderful returns for stocks, but there are some patches with absolutely terrible returns – see the great depression years. An investment of $100 at the beginning of 1928 would have fallen to $44.31 at the end of 1932. Trying times indeed!
Source: created by author using historical return data
The following graphic takes the returns for stocks and bonds for each of the 91 years in the dataset and bins them into categories based on their returns. Note how wide the spread is for stocks compared to bonds. It shows in rather clear terms, the potential spread of returns for stocks, and how that spread (both positive and negative) is less for bonds.
Source: created by author using historical return data
One final view of the historical data provides additional insight. This table shows the historical percentage of years with various amounts of gains and losses. Clearly bonds have historically done a better job at keeping their value, but come with reduced potential upside.
Source: created by author using historical return data
The Modeling Approach
I researched various approaches to withdrawing money in retirement and the “bucket method” seemed the most logical to me. It is able to handle the immediate, short term and long term needs of a retiree.
Here’s an explanation about the bucket withdrawal strategy from Investopedia:
Bucket or segmentation strategies divide assets into different ‘buckets,’ depending on the time remaining until withdrawal and the client’s risk appetite. For example, the first bucket may contain cash and cash equivalents needed over the next five years, while the last bucket may contain riskier equities that won’t have to be sold for a decade or more. These buckets can be rebalanced at any time to reflect changes in income requirements or risk tolerance.
The buckets: In my modeling I used 3 different buckets:
Cash: Cash or cash equivalents that can be easily withdrawn. This bucket also serves a psychological purpose: holding more than a year’s worth of cash helps the retiree know that they have a solid place to withdraw cash for a year or two in the future. This may help assuage retirees concerns and fears during drastic market downturns.
Bonds: Money needed in the intermediate term is stored in bonds. We won’t see spectacular returns…