How Do You Know if You’re Running Out of Money in Retirement?

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Conventional financial planning feeds off the mathematics of accumulation portfolios, where you’re still saving for retirement. We’ve all heard about the magic of compound interest, dollar cost averaging, and stocks for the long run….

But the math behind distribution portfolios, where you actually need to live off your money, is shockingly different. A distribution portfolio is far more fragile, far less likely to grow, than an accumulation portfolio — because, regardless of what the markets do, it is already under stress from your regular withdrawals.

Little do most retirees, or even most financial planners, understand this.

So, if you must be more careful with a distribution portfolio, what are the warning signs that yours could be in trouble?

The Mathematics of Loss

Let’s start with a very simple example. If you lose 10% on your investments one year, how much do you need to make next year just to get back to even? The answer is more than 10%, because you now have less capital to work with. In fact, with only 90% of your original capital, you now need to make slightly more than 11% to get back where you started (10/90*100).

Perhaps that doesn’t sound too bad. But what about more serious losses of say 30%, or 50%? (Remember 2008-2009.) Well, it turns out you need to make about 43% to recover from a 30% loss, and an astounding 100% to recover from a 50% loss! Getting those kinds of stock market returns over a short time span is about as likely as winning the lottery, especially in today’s economic climate.

Distribution Portfolios

So you simply can’t afford to take substantial losses in your retirement portfolio. But it’s even more serious than that. Because, once you begin distributions from a portfolio, it becomes even less resilient to losses. A sideways market, one that fluctuates up and down within a range for years, can produce modest returns in an accumulation portfolio. But it’s generally bad news for a distribution portfolio. 

This is due to the effects of reverse dollar cost averaging. For the same reason that dollar cost averaging is a good thing in accumulation portfolios — because you buy more shares, on average, when prices are cheap — it’s a bad thing in distribution portfolios. That’s because you must sell more shares when prices are low, just to support the same standard of living. Once you sell those shares to live on, you are "locking in" losses. That money is gone and can never earn for you again. And those losses erode your working capital at a disturbing clip….

Just consider this simplified example: Suppose we encounter another run-of-the-mill bear market, a 20% decline. Given the mathematics of loss that we explored above, you’d need to make 25% the next year to break even. But what if you are living off your portfolio at the same time, withdrawing at the supposedly "safe" 4% rate? All of a sudden you need to make back about 32%, instead of that already-daunting 25%. Now imagine that withdrawal penalty compounded every year for several years during an extended bear market, and you get a sense of the magnitude of the issue. You can very rapidly dig a hole from which you’ll never escape….

Watching for Signs of Trouble

Nevertheless, many of us will try living off our investment portfolios for some or all of our retirement years. Even if you eventually decide to annuitize — pay a portion of your portfolio to an insurance company in exchange for a guaranteed lifetime income — you may initially try going it alone. Unless your investment assets far exceed your expenses, you must be ever-watchful for economic conditions that could damage your portfolio such that you’d suffer a reduced standard of living for the rest of your life.

My simple rule of thumb based on current research is that, unless your annual expenses are less than about 2-3% of your portfolio, you fall into this "must be watchful" group. That’s right, current research on how market valuations predict retirement portfolio success shows that the conventional advice about living on 4% of your assets annually is not now a guaranteed route to financial security in retirement, if it ever was.

So what do we mean by "watchful?" Can we quantify certain precise warning signals that will alert us if our portfolio is in danger of suffering irreparable damage?

As assets grow over time, it becomes more and more difficult to measure your progress. If you’re young, with little in savings, adding a few thousand dollars a year, the results are pretty obvious. Regardless of the market’s direction — your savings grow.

But if you retire with $1 million and live off just a few percent of that each year, market fluctuations will dwarf your withdrawals. It’s like sailing a small boat in a storm at sea. You are tossed up and down as one giant wave arrives after another, and it’s very difficult to detect whether progress is forwards, backwards, or sideways. This phenomenon makes it extremely difficult to understand the impact of your own withdrawals. It’s hard to really see whether you are on track or not.

My Warning Signs

When I retired a while back, with little specific knowledge of how to manage a distribution portfolio, I had a couple of simple warning signs in mind. We had set aside two years of cash for the start of my retirement, as is often recommended, so a two-year horizon seemed sensible.

I figured if our net worth went down in the first year, I’d start keeping on eye on things. If another year passed, and our net worth went down again, that would be enough warning to trigger some action. Either we’d cut our living expenses significantly, or I would ramp up my part-time work efforts. (Later in retirement, if I could no longer work, we’d probably need to buy an annuity.)

As it turns out, we have not hit that warning level. In fact our portfolio has grown just a bit over the past year and a half. I’ve also learned that a two-year window is a bit conservative. You’d better be prepared to see your net worth go down for more than a couple of years, especially when you are no longer accumulating assets, because the average length of a stock market cycle from peak to peak is more like 5 years!

In the longer term, I had in mind another simple warning signal that would require a response on my part: being forced to sell at a loss. The game plan was never to sell any investment for significantly less than I had paid. If I did, that would indicate things were going badly. And perhaps that’s true, but it’s not really a practical indicator. With more or less half our portfolio in short and medium-term bonds, we could go nearly half our retirement with very little likelihood of selling at a loss. But, that would by no means ensure success for the second half, if our equities didn’t eventually perform!

Better Warning Signs

I’ve since learned of several more sophisticated, though still not foolproof, approaches to this problem of knowing whether you’re starting to run out of money in retirement….

Let’s begin with the withdrawal rate itself. I’ve read countless studies of what this rate can or should be, depending on market history and/or current market conditions. In virtually no case does any modern expert recommend a safe withdrawal rate over 5% early in retirement. So that is one simple warning sign: if your annual withdrawal rate should approach 5% at the start of a 30-40 year retirement, you are almost surely in trouble. But note that the reverse is not true: Just because your withdrawal rate is below 5%, doesn’t mean you’re not in trouble!

That’s because we have learned that current market valuations, as reflected by price-earnings ratios, are a reasonably reliable indicator of retirement portfolio success. As I write this, the Shiller PE10 is in the low 20’s, high by historical standards. This means there is a strong statistical tendency for reduced market returns going forward from today. So that is another warning sign: if the Shiller PE10 is above the historical average when you retire, consider yourself on notice.

The final warning signal I’ll discuss is related to my earlier two-year threshold, but has a stronger basis in research. It’s the Fourth-Year Check-Up presented in Jim Otar’s Unveiling The Retirement Myth.

Otar derived this warning signal by calculating the values of many retirement portfolios for each possible historical retirement period, starting in 1900. He looked at those values after 4 years of retirement, and then again after 20 years. He found that the winners after 4 years had a much higher survival rate in the long run. (Though he used higher than usual withdrawal rates in his analysis, I like that this makes for a conservative test.)

So the Fourth-Year Check-Up signal is very easy to monitor, as long as you already track your net worth or total portfolio value. You simply compare that value on the 4th anniversary of your retirement, to the original number when you retired: Is it more or less? If less, this is an indication that the sequence of market returns has been working against you, and there is now a higher probability of running out of money before you run out of life. The good news is that you are only four years into your retirement, so you may still have some flexibility and options for improving your situation.

And that’s it: a difficult and disturbing topic that will be very much on your mind once you start living off your assets in retirement: How can I know if I’m starting to run out of money?

As we learned, the dangers to a distribution portfolio are far more severe than those to an accumulation portfolio. Fortunately, there are some simple warning signs you can check to know if you’re on track. Unfortunately, they aren’t entirely accurate, and could be too conservative for your situation, leading you to work longer, spend less, or annuitize too much.

But, if you place a high value on lifetime income — never running out of money — you will heed those warnings….


  1. Thanks for delving into a topic that needs more enlightenment!

  2. Darrow Kirkpatrick says:

    Thanks George. There's definitely more to learn and say on this topic…