Retirees need to carefully analyze investment plans

Posted: Tuesday, September 26, 2000

"First, people have been working under the assumption that the stock market is going to provide a certain return, and that assumption may not hold true."

-- Michelle Augustine

Financial planner

DENVER (AP) -- Smart investors know it's dangerous to assume too much about how well their portfolio will perform in the future.

For retirees, the wrong assumptions about the future performance of their nest egg can be especially painful because they generally have less time and ability to correct for miscalculations than those building a nest egg, an investment expert at the College for Financial Planning warns.

People entering retirement typically estimate how much their nest egg will earn on average each year for the rest of their retirement and then calculate how much they can safely withdraw from the portfolio each year -- taking into account inflation -- so they don't run out of money.

But retirees are making three common mistakes these days when making that withdrawal calculation, says Michelle Augustine, chairperson for the Masters of Science-Financial Planning.

''First, people have been working under the assumption that the stock market is going to provide a certain return, and that assumption may not hold true,'' she says. The assumption is that the stock market is going to continue to return 20 percent to 30 percent a year as it has in the last several years.

Yet, as Augustine points out, the stock market historically has returned around 11 percent a year. ''We are setting ourselves up for a fall or we have a false sense of security if we assume the market won't retreat closer to its historical average. Even a 1 percent difference in average return compounded over 10 years is pretty significant, let alone a drop from say 20 percent to 11 percent, or even lower.''

A second risky assumption is that the individual retiree will actually do as well or better than the market average. For example, says Augustine, many retirees are invested in mutual funds, and the majority of mutual funds underperform the market in most years.

Worse for many investors is that they often underperform the funds they invest in because they jump in and out of the market too much. A 1999 study by the Boston-based research firm DALBAR Inc. found that fund investors earned an annual average of 7.25 percent over a recent 15-year period while the funds themselves earned an average of 17.9 percent during the same period.

In addition, investors need to step back and look at their overall portfolio when projecting future returns, says Augustine. Most nest eggs include investments other than just stocks, including bonds, cash, annuities, life insurance and perhaps real estate. Retirees need to include these investments in their estimate, not just on how well they think the stock market or stock mutual funds will perform.

The other major risk for retirees when estimating how well their portfolio might perform over the course of their retirement is to base that estimate solely on ''average'' return, even if that assumed average is a modest one. When someone says the stock market ''averages'' an 11 percent return a year, that doesn't mean the market returns 11 percent every year, says Augustine.

It might return 18 percent one year, lose 9 percent another, and gain 24 percent in another, for a three-year positive average of 11 percent. But the order or timing of those returns makes a big difference in the actual dollars the investor ends up with after those three years.

The danger of depending on ''average'' is well illustrated by a study by the mutual fund company T. Rowe Price, says Augustine. The company assumed a couple had a $1 million nest egg beginning in 1968. The portfolio was 60 percent in stocks, 30 percent in bonds, and 10 percent in cash. Over the next 30 years, the average annual return of that portfolio was 11.7 percent a year. Based on that ''average'' return, the couple could have spent $85,000 that first year, and adjusted that withdrawal amount upward 3 percent every year to account for average inflation. Their money would have lasted for 30 years.

But based on actual year-to-year returns during that period, the couple would have exhausted their account in only 13 years. Why? Augustine says the study found that the account would have lost much of its value early on by the devastating 1973-74 bear market, which knocked off 40 percent in stock values. Consequently, maintaining $85,000 annual withdrawals, adjusted upward for inflation (which was high during the 1970s) would have depleted it more rapidly.

The account would have run out of money just before the bull market started in 1982. If the order of market returns had been reversed -- today's high returns coming first and the 1973-74 bear market coming much later -- the account would have had plenty of money left in it at the end of the 30 years, says Augustine.

So retirees need to be very cautious in the return assumptions they make when initially determining how much to withdraw in a year. Some studies have suggested withdraw rates of 4 percent to 5 percent are much safer. Augustine also recommends that retirees be prepared to reduce the amount of their planned withdrawals during down market years.

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