When you’re in the middle of a project, it’s sometimes hard to imagine the final result. But, that stash of cash in your 401(k) will someday be your income, and you’ll be taking money out of it rather than putting money in it.
The strategies for investing while you’re taking withdrawals are significantly different from the strategies for investing while you’re still saving. Funds that guard against big losses in a bear market, for instance, might be better than those that post big gains in a bull market.
To illustrate how dramatically withdrawals can change your investment strategies, take a look at how the 15 largest stock funds of 1996 would have fared after 10 years of withdrawals. 
This 10 year period is telling because the decade encompassed pretty much every type of investment phase imaginable. Stocks enjoyed an astonishing bull market from 1997 through 2000, endured a bone-jarring bear market from 2000 through 2002 and finally skated through a relatively mild bull market for the rest of the period.
Naturally, funds that produced the highest total returns in the past 10 years left you with the most money at the end of the period. Fidelity Contrafund gained about 180% for the 10 years that ended in 2006. Even after withdrawing $106,259 — an initial 8% withdrawal rate — you’d still have $107,664 left in your account after 10 years. But, avoiding big losses was even more important than scoring big gains.
American Century Ultra jumped 42% in 1999, compared with 25% for Fidelity Contrafund. By the end of 1999, your Ultra balance would have been $166,741, vs. $152,223 for Contrafund, assuming you began with an 8% withdrawal rate.
Bear markets, though, hurt you much more when you’re taking money out of your account. Ultra lost 19.9% in 2000, 14.6% in 2001 and 23.2% in 2002. By the end of 2002, your Ultra account would have fallen to $66,520, including withdrawals.
By contrast, Contrafund’s worst calendar-year loss from 2000 through 2002 was a 12.6% tumble in 2001. By the end of 2002, your Contrafund account would have stood at $86,372.
A 1998 study by three professors at Trinity University in Texas looked at success rates in retirement, using different withdrawal rates. Success, to the authors, meant having money left after 30 years. They reviewed stock returns from 1926 through 1995 and adjusted withdrawals for inflation each year. If you started with a 5% withdrawal rate in an all-stock portfolio, your success rate was 85%. If you started with an 8% withdrawal rate, your success rate plunged to 41%.
The Trinity study found that an all-bond portfolio had just a 17% success rate after 30 years — and that’s if you started with a 5% withdrawal rate. A mix of 50% stocks and 50% bonds raised the success rate to 76%.
The top funds of any given 10-year period will rarely be the best funds over the next 10 years. But, if you start taking small withdrawals and try to limit your losses by choosing an appropriate asset allocation, your money could last longer than you imagine.
I believe 4% is the standard safe rate of withdrawal given by US writers on this subject, as you probably know. In the UK, where we’re lucky enough to have high dividend paying stocks, I hope to eventually live off their yield off my investments (the income paid by the stocks) rather than selling them down.
Yes, I’m still ‘withdrawing’ but crucially I will not be forced to sell any stocks at a bad time, which I suspect will make a difference over the long run.
‘Standard’ withdrawal rates vary greatly by writer, and depend upon the tools that you use. For example, ‘worse case scenario planning’ (and, when it comes to your retirement should you accept only a 75% – 90% chance of success???) using:
1. Monte-Carlo Analysis generally yields ‘safe withdrawal rates’ as low as 2.5% – 3.5%.
2. Straight line methods yield rates as high as 7%.
3. Various analysts yield rates somewhere in the middle
Which do you believe … given that your ENTIRE FUTURE depends upon getting this number right?
As to how/where to invest; try these two excellent resources:
a) Worry Free Investing by Zvi Bodie – a retirement investment strategy with built-in inflation protection (using TIPS; US treasury bonds that are inflation-protected), and
b) The Grangaard Strategy by Paul Grangaard – uses a combination of stocks and ‘bond-ladders’ to generate (he claims) a 6.6% retirement stream.
Good Luck … and thanks for the great post! AJC.
AJC.
Interesting article. I, like Monevator, plan to mitigate the problem with a sound dividend strategy. It will pay me steadily increasing income over time.
Best Wishes,
D4L
My plan is to start with 4%, but then don’t increase it for inflation each year. Just keep withdrawing 4%. Over time, this will tend to increase, but this does mean that some years my income will be much higher than other years and some years much lower. In the years with extra money, I will put that money in a bond fund or something like that. In the years with less money, I can withdraw from that fund. And of course I can spend bigger in the years where I get more money and spend less in the years when I get less money.
I figure this way my money will last me forever, which I need since I plan to retire young and live to be old. (Thirty years? Hah!) My only risk will be that some years will be tight. My house will be paid off before I retire, so I could get expenses down quite low if I needed to.
When I first retire, I’ll start with some small percentage in the bond-like fund: more if the market has been skyrocketing, less if it’s been plummeting.
Clint thanks for sharing useful information.
Although, I would like to add one more thing that you will always bear fruitful results if your outlook for investment is long term.
Jeff Clair