Don’t Rely On A Straight-Line Model For Your Retirement Planning

You might have a hard time believing this is actually out there, but make sure you don’t use a straight-line model in retirement planning when you try to determine the appropriate amount of withdrawals you can take from a portfolio without running out of money. Using the straight-line method, the software will assume that you earn the average return every year on your asset allocation and that you are taking a fixed dollar amount out every year, adjusting it annually for inflation.

Assuming that your portfolio is half in stocks and half in bonds, the software may assume that you will earn 6% per year, every year. It will further assume that any withdrawal amount less than that will work forever, without you ever running out of money.
Using this type of software and this scenario shows you accumulating money ad infinitum. For example, if you have \$500,000, any withdrawal amount under \$30,000 (6% of \$500,000) will work out fine, and the excess amount will be added back to your principal over and over again. It’s a nice theory. It just doesn’t work often enough to rely on it.

If you were to retire at the beginning of a bear market, commonly defined as a time when stocks in general go down 20% from their previous highs, you would run out of money much faster than the straight-line method would predict. And as you can probably guess, running out of money is the worst financial planning error you can make.

Let‘s go through a couple of examples to show what can happen. In a year when things go well, using the straight-line method, starting with \$500,000, expecting and getting an 6% return, and using a 5% withdrawal rate, at the end of the first year you would expect to have \$505,000, or \$5,000 more than you started with, even factoring a large withdrawal of 5% of your portfolio. \$500,000 [Initial Amount] + (6% or \$30,000) [Investment Returns] – (5% or \$25,000) [Withdrawals] = \$505,000.

However, what if bonds provided their expected 4% return, but stocks went down 20%, and you still took out \$25,000? Your portfolio would have suffered an 8% loss [.50 x .04] + [.50 x -.20] = .02 + (-.10) = -.08, and you would have compounded the decline even further by taking the 5% of the starting value. You would have ended the year at \$435,000. \$500,000 [Initial Amount] – (5% or \$25,000) [Investment Returns] – (8% or \$40,000) [Withdrawal Amount] = \$435,000 [Ending Value].

Now, after just one bad year you have about 13.8% (\$70,000) less than you thought you would. (You have \$435,000 instead of \$505,000.) Even if your year 2 returns are flat, meaning not up or down, by the end of year 2 you would have \$410,000 in your account (\$435,000-\$25,000 = \$410,000). Well, what if one bad year turns into two, or three, or more bad years, similar to the ones we had just a few years ago? And these were bad just for stocks. Most bonds did well during the recent bear market in stocks. If you were properly allocated, it did a lot to cushion the blow.

What if, like many people, you did not have enough money in bonds during the bear market years? What if both stocks and bonds did poorly at the same time for a few years? It certainly has happened before, and it will happen again. Straight-line is clearly not the way to go.