Finding Out How Much Money You’ll Have in Retirement

Paul Winkler: Welcome to the second hour of “The Investor Coaching Show.” I’m Paul Winkler, here to talk money and investing. Let’s get a little practical here, shall we?

Social Security

So, we put money away, and hopefully, if we invest this stuff right, we can live off of this future. People often, hopefully, live on less than they make. The idea is income exceeds expenses, as I often will draw the graph.

You’ve got your income up here and a line going horizontal from left to right, and then you’ve got your expenses, which will be a line below that, and the difference between them is savings. Then what happens is eventually, expenses go on because you have to pay for stuff until you stop fogging a mirror. So that line keeps going. That expense line goes till death do you part.

Well, the line on the top will go until you retire, and then it drops and it goes down. Now, part of what it’s replaced with is Social Security. Then the difference between your expenses and Social Security is savings, personal savings. And that’s the idea behind it.

So if we look at Social Security, somewhere in the neighborhood of typically around 40, 45% of your income in retirement is replaced by Social Security depending on your budget. Now, if you’re Bill Gates, it doesn’t work that way, right? If you have a huge budget and you spend a ton of money, Social Security is just a blip on the radar screen.

But for most people, it’s about 40%. That’s a pretty normal number.

The rest of what you need, pensions used to fill the gap between the two, what your expenses were and what your income from Social Security was, but that’s becoming less of a deal now. Most of it’s private saving.

So you go through that stage where you’re working for money, you’re producing an income, and when we get to retirement, I am still, I’m typically going to still have a significant amount of assets in stocks, large companies, small companies, large value, small value, international, international small, international small value, and blah, blah, blah, emerging markets, all these different things. And now instead of having one person at work, as I like to explain it to people, me at work, now I’ve got millions and millions and millions and millions of people around the globe at work on my behalf, because I own the companies that they work at.

That’s the idea. That’s the idea behind investing.

Now, I might have somewhere in the neighborhood of anywhere from 25 to 50% of my money in bonds. That’s because I want to have something that is absolutely stable no matter what’s happening.

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But I recognize that my ability to outpace inflation is just about slim to none with bonds and fixed income investments. 

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So stocks protect against inflation, protect against the fact that prices just keep going up as I go through retirement.

How Much Income Will You Have in Retirement?

Now, Social Security has an inflation protection element in it, and this is where it can get really dicey if I’m focusing all my assets. I did a video recently where I said, “Hey, what if you took your required minimum distribution and I took it all from CDs?”

And what I basically showed in that video is if you looked back to the year 2000 till now, the income that you took when you first started 25 years ago would be actually higher than what it would’ve been now, because of the way required minimum distributions worked. So you would’ve had no cost of living increase with CDs or a fixed income investment like that as my investment vehicle for required minimum distributions. That’s pretty bad stuff.

Now, I also did a video where I actually looked at what would happen if you did what I’ve been talking about forever on this show. And we actually used actual client returns in the video. So it was kind of cool because we actually, believe it or not, go to an investment provider and say, “Hey, what were your actual client returns?”

And they’ll look at you like deer in the headlights. You ought to know that kind of stuff.

But anyway, I digress. So how do we figure out how much income we’re going to have in retirement? Well, number one, one of the things that I look at is the type of assets that I hold.

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So if I’m in the accumulation phase, I’m putting money away for retirement, I want to look at what areas, what markets I’m invested in.

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Now, if you’re in your twenties or thirties, mainly stocks, right? That’s typically where you’re going to be is mainly stocks.

Now, I can look at large U.S. companies and say, “Well after inflation, with CDs it’s like zero after inflation return. In large U.S. stocks, it’s about 7% after inflation. So positive 7% return after inflation. For small companies about 9%.”

If I look at large value stocks, we hear about Warren Buffett being a value investor, you look at that and it’s somewhere in the neighborhood of 11, 11 1/2, somewhere in that neighborhood, rate of return. And then after inflation, somewhere in the neighborhood of about 8, 8 1/2, okay?

Now, if we look at small-value stocks, it’s about 11 after inflation. If I look at international, about six, seven, after inflation. Small international stocks, 10, 11 after inflation.

If I know what I’m exposed to, if I know how much money I have in these areas, I know the expected return of those things, I can go, “Hey, this is about the expected return of my portfolio.” Now I can project into the future and I can go, “This is how much money I’m likely to have.”

Linear Return Function

Now, what can throw a wrench in this is the order of returns. Before I go into the order of returns, let me make sure you get this idea.

So if I have only two asset classes, I’ve got small U.S. stocks, expected return of nine after inflation, and large U.S. stocks, expected return seven after inflation. If I put them two together, I put those two together.

Did I actually say to put the two together? I did. Nick, didn’t I? Ha, ha, ha. Wow.

If I put those two things together, I have an expected return of between seven and nine, let’s say eight, okay? So that’s my expected return.

Now I can take that number — it sounds like I’ve got chocolate and I’ve got peanut butter. I’ve got my Reese’s Peanut Butter Cup — I put the seven and the nine together, and I mix them together. And that’s what I’ve got.

Now, I can put that into a calculator and use a linear return function. And this is often what you’ll see at work. You see these work-based plans, they’re just doing a linear return.

In other words, if you get a rate of return of nine, nine, nine, nine, nine, nine, nine, and seven, and seven, seven, seven, seven, seven, all the way up through your entire work history, here’s how much money you’ll likely have. That’s not necessarily terribly helpful.

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The reason it’s not helpful is the order of returns will vary significantly.

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You could have a period of time where it’s -5, -10, and you have terrible returns followed by great returns, and then terrible returns, and great returns.

And the amount of money you’ll have can vary significantly. Then you could have the same expected return, your long-term return could be nine, let’s say, but it could be that you have really, really bad returns in the early years and great returns later on, and it averages out at nine.

If that happens, you’re going to be dancing and go, “Oh, happy day,” if you are accumulating money for retirement.

Well, why? Because when you had the bad returns in the early years, you were putting money away, putting it away, putting it away. And every time you bought, you bought at lower and lower and lower prices.

And then, all of a sudden when it comes back toward the end and you have the great returns, you’re like, “I owned a lot of shares when it came back because I kept buying at lower and lower prices. I followed that golden rule of investing wonderfully.”

Nick’s nodding yes, so I’m loving it. That means he’s getting this.

Now, if on the other hand, you have high returns in the early years, you’re buying at higher and higher and higher and higher prices, you’re putting money away, and then it goes down just before you retire, you’re going, “Oh, not happy day.” And that is the issue with order of returns.

Order of Returns

So what do you do to try to figure out if you’re likely to be okay? Well, what happens is, you can use some really sophisticated software programs, and I’ve been teaching on this stuff for years and years and years.

And you know, I taught financial advisors on this topic 25, 30 years ago, because that’s when I was getting into these new programs that were coming out that were doing these things. Well, what you can do is you can actually play around with orders of returns and have different iterations.

So what you can do is you can say, “Well, what if the returns in my portfolio were like they were in 1935, followed by 1978, followed by the returns that happened in 1955, followed by the returns that happened in 2007? Well, what if we reverse that? What if it’s 2007 followed by 1955, followed by 1938?” And you can go and change those orders a thousand times or more.

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Then what happens is you get an idea, you get a range now, of what the likely outcome will be based on your portfolio design.

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Now, let me back up and go, “Well, what about why those returns are going to be what is likely to happen in the future?” Glad you asked.

If you look at large U.S. stocks and you look at every 30-year period, it has been within about a percent of 10% return. So what would lead me to believe that that might likely be possibly the cost of capital or the expected return in the future?

Prices of stocks compared to earnings now, versus prices compared to earnings 70 years ago, 50 years ago, 80 years ago. If those numbers are pretty close to the same, then my expected return should be about the same, because if that continues, I’m not paying any more or any less than I ever have. And that would mean since I get the rights to the earnings that the expected return should be fairly close.

So that’s why when I look at these things and I’m teaching on it, I go and I’ll show people, “Hey, here’s the return of this. Or, here’s the price of these particular assets that we’re owning.”

And when you see that it’s right in the range that it’s always been, that gives you that warm fuzzy of going, “Oh, wow, the return expectations that we’re using in this software are right about right.”

Making Assumptions About Future Market Returns

Now, here’s the problem you run into is, garbage in, garbage out. And I’ve seen where people put numbers in these programs that are just wrong, because they will make assumptions about future returns in markets.

There was this one guy who is a professor who did this. Oh, I’m going back 20 years. I’ll never forget. I don’t want to throw his name under the bus because he ended up being totally wrong.

But he said, “I believe that the expected returns in the future in the markets are going to be lower.” Now, he was wrong. The returns were actually the same as they’d ever been, but he said, “I think they’re going to be lower, and here’s the reason I think it’s going to be lower.”

And I got up to a microphone and I said, “Professor, let me ask something.” And I said, “Glad you’re here, love that you’re here.” And I said, “You had said in one of your studies that stock markets were more volatile today on an individual stock level than they had been in previous decades. So, stocks are actually more volatile today.”

And he said, “Yep.” And he told the audience about the study.

“And you had made the comment that because of that, but interestingly, individual companies were more volatile than they had been in historical periods in the past, but that markets themselves were not any more volatile. So the individual components of the market, Microsoft stock, Nvidia, Walmart, Home Depot, whatever, those stocks were going up and down, with much, much greater amplitude in how much they go up and down, okay? But if you look at the whole market as a whole, take all those components and put it together, so instead of the individual ships on the sea bobbing up and down a lot, let’s look at the whole sea and look at all the ships, and now we see that they’re going up and down at about the same rate they’ve ever gone up and down. If markets are no more volatile, but individual stocks are more volatile, why would we expect returns, which is compensation for putting up with volatility, to be lower?”

It was absolute nonsense that came out of his mouth next. And this is it. And this is a guy that believed in what we call “market efficiency.” He believed that stock picking and market timing were failed methods of managing money.

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Yet, he fell into that very trap of predicting what future returns would be. In essence, it’s a form — a subtle form — of market timing in a way.

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Because if I think this market’s going to have a lower return than historic, I would go over to another market that might have a higher return expectation. So, you can be pulled into doing things that are different based on predicting the future in this way.

The Multifactor Theory and Efficient Market Hypothesis

But if you look at this and say, “Okay, now I know what areas of the market that I hold, and I know the mixes between large and small and value and growth in U.S. and international, now I can project in the future. Now I have tools that I can take that volatility and the standard deviation or the amount of ups and downs into account, now I got something. Now I can figure out, do I have enough money to get the income that I will need in retirement?” And you can do that throughout retirement.

This is what I think is so critical and such a great tool. And to me, it’s interesting because a lot of people, they’re using simplified versions of this, but you really want to make sure that the numbers going in are right, the standard deviation numbers.

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Too often, you just have the linear method of doing it. That means no standard deviation. That gives you that there’s no risk. 

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You got linear, 10% return, 10% return, 10, 10, 10, 10, 10, 10 all the way in the future. But the problem that you run into is you could have very, very different outcomes. So make sure that you’re dealing with both of those numbers and that both of those numbers are well-founded.

The beauty of it is, this is multifactor theory and efficient market hypothesis. All of this stuff is Nobel Prize-winning research, and it needs to be used when you’re doing this type of planning for the future.

And of course, you also want to take into account taxes. But your biggest determinant, studies show, is return factors. Taxes are definitely important, but what happens is people, actually, they get a little bit lazy when it comes to how to make these projections. And I wanted you to be aware that this stuff exists out there.

You are listening to “The Investor Coaching Show.” I am Paul Winkler. I got lots more news after this.

We got some fun stuff. Buying on the dips, have you ever thought about buying on the dips in the stock market?

Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.