Today we’re going to take a good look at the three numbers most retirement calculators make you just guess. All three are very arbitrary and are based on future market and economic performance.
Inflation and Market Return
For ease of use, I like to combine inflation and market return. Often, when the market is high, so is inflation. But that’s not always true. So, luckily, some very nice people have combined the two metrics for us in an overview of historic market performance. All charts we discuss below are adjusted for inflation.
To start our discussion of interest you can expect from the market, or annual market returns, I want to have you look at a chart created by Political Calculations Blog.
Alright, so this chart was made in 2007, so it doesn’t include 2009, but it looks at the worst possible market returns based on how long you stay in the market. A few things we learn here:
- The length of time in the market matters. Somewhere between 20 years and 21 years in the market, the WORST return is positive. That means no one lost any money staying in the market for more than 21 years.
- 75% of the worst-case scenario market options end in two specific periods:
- 1920-1921 – a period of the worst inflation rates in U.S. history – inflation rates near 20%!
- 1932 – more specifically, June 1932 when the greatest crash in stock market history hit its lowest point.
Now, knowing that we need to stay in the market at least 20 years, lets look at historical market data for every 20-year rolling period in history thanks to awesome-sauce charts made by AllFinancialMatters.
I want you to focus on the “Average Annual Net Compound Return” in the gray area titled “inflation-adjusted returns.” This column shows (adjusted for inflation, obviously), the average percentage at which the portfolio grew each year during that cycle. Now, you can see that market returns are all over the board. They go from just over zero to a crazy 13.05%. (If we could count on 13.05%, our $70,878 in investments would turn into over $950,000 in 20 years without us adding a penny more!) Now, here’s some helpful information based on this chart to help you decide what rate you would like to use for your calculations based on your risk level:
- The average is around 8%
- The median is around 7%
- If you drop the 10 highest periods and the 5 lowest periods (to remove outliers, but still be on the conservative side), the average is 6.71%
- Using only the bottom half of the periods – or the worst half of all the rolling periods, the average is 3.88% and the median is 4.66%
Based on this data, Mr. T and I are very comfortable planning an inflation-adjusted 4% annual market return. This means we can ignore inflation projections, plan for 4% in our compound interest calculations. In years where the market does much better, we can be pleasantly surprised.
Safe Withdrawal Rate
I had planned to examine this area much more in depth, but Justin over at Root of Good just last week posted an ultimate look at the 4 Percent Rule with links to all the other great blog posts on the topic at the bottom. Definitely check that out. What I do want to mention, briefly, are some graphs from a study published in 1994.* These graphs show how many years a portfolio would last, historically, if the person started withdrawing 3% or 4% of the funds the first year and then that same amount of money, adjusted for inflation, each year. They capped the chart out at 50 for the number of years the portfolio would last.
My favorite line in the whole study: “Figure l(a) (three-percent withdrawal rate) is as exciting as a crewcut.” This crewcut-like excitement continues up until about 3.5%. So, 4% is probably safe, but if you want to make sure you’re going “crewcut” in your retirement planning, count on a 3.25-3.5% withdrawal rate.
On Friday, we’ll combine Monday’s look at our spending with the numbers we looked at today and draft a whole new early retirement plan for the Banks Family! And we’ll want your input!
*I’m aware this study is old, doesn’t include the recession, etc. But it basically leads to the same conclusions most studies looking at the historical data do.
Also, in case anyone actually thinks I know anything: No one should take this as investment advice. This whole blog is for entertainment and discussion.