Math Is Not Money – And Money Is Not Math!

Years ago most companies would provide retirement plans that guaranteed an income for the rest of your life. These plans were called Defined Benefit Pension Plans and when you retired they gave you a percentage of your income for the rest of your life. Many of these types of pensions have gone away, replaced by a 401K where employees put their money into the stock market for the most part. Some people still have another type of defined benefit pension plan in essence, called Social Security. When they retire at age 65-67, they get social security income which continues for the rest of their lives, but this usually represents only a small percentage of what is their required annual income.

What we are suggesting is that people build their own defined benefit pension plan that will create guaranteed income for the rest of their life. For instance, if you need $100,000 a year to live on and social security provides $20,000 of that, we want to try and backfill that other 80% with guaranteed income. We do this by taking some of the money they have in the market or sitting in cash or CDs etc., and putting it into products that help people have the confidence to enjoy their retirement and not feel that their money is going to run out. The challenge that many people face as they approach retirement is determining how much yearly income they will need and for how long they will need it. When people try to figure this out, they usually approach it in a mathematical way.

For instance, let’s say that a potential retiree wants to generate an income of $300,000 a year. Mathematically, if they had $5 million in assets earning 6% every year, then they could take out $300,000 each year. Seems simple, doesn’t it? However, that kind of mathematical calculation creates a really dangerous potential result and here is an example of why. In the 26 year period from 1969 to 1995, the Standard & Poor’s 500 Index showed average yearly earnings of 11.3%. Hypothetically, if we took our $5 million retirement nest egg, and withdrew our $300,000 a year based upon that S&P Index, even increasing it every year to hedge against a 3% inflation increase, we would not only have been able to take out all that money but the portfolio would have grown from $5 million all the way up to $25 million. That has to do with the fact that in the early stages of that 26 year period, the market did very well.

But here’s the catch. If we followed our plan outlined above but reversed the sequence of events of the S&P 500 so the progression of the rate of return was inverted from the first year to the last year and from the last year to the first year, we would still have that yearly average of 11.3% but in that situation, we would end up basically broke. Instead of having $25 million, we would end up with $190,000, even though the portfolio still averaged 11.3% a year.

When we show this to people, they are usually quite astounded because the rate of return averaged 11.3% in both scenarios. If we were just saving money during that period of time, it would have been the exact same amount of money at the end of the period. In other words, hypothetically, if we put X amount of dollars into the investment in the beginning and let it grow for that 25 years, the sequence of events – – which year had a better return, the first or the second – – doesn’t really matter. However, when you are taking money out, the results vary tremendously.

In both scenarios outlined above, the average yearly earning is the same, 11.3%, but the results are vastly different. Why? If the earnings are not good, then our portfolio decreases, decreasing the amount we can earn for the next year. When you are distributing money and taking it out of a portfolio that loses money it has a compounding effect. We call the first chart which shows growth a mountain chart, while the second chart is a canyon chart. But what if you manage to earn 11.3% every year? You would find that at the end of that 26 year period, you wouldn’t have $25 million, but would actually have $30 million. Again, the average yearly income is still 11.3% but because every year you earn that 11.3%, the outcome is very different from the other 2 scenarios.

The one thing we don’t know is how well the market is going to perform. What we do know is that it is going to perform differently and we are not in control of it. This can lead to tremendous variability in results. This is why we say “Money is not Math and Math is not Money.” We think it is very important for people to protect themselves by having different “buckets” of money rather than just one that could potentially be subject to this kind of result. We want our clients to become aware of the risks of having all their money tied to one type of investment or one type of portfolio and develop alternative plans that protect them so they are going to have a guaranteed income for the rest of their lives that they cannot outlive, and that can only go up no matter what happens in the market. We call that the 20% Solution. We suggest people consider taking 20% of their portfolios and putting it into vehicles that have significant guarantees so that if the market does not perform well, they and their money will still be OK. Do you have your 20% safety net in place or will you be the victim of the vagaries of the stock market? Call us. We can help.