Monday, July 22, 2013

Cashing Out

I recently received an interesting e-mail from a friend nearing retirement. He told me that he believed his portfolio had recently reached seven figures and wondered if I thought he should “cash out” soon.

I wasn’t sure precisely what he meant by “cash out”, though I assumed he meant sell his stocks and probably his bonds, so I asked, “What would you do with the money if you cashed out?”

“Retire,” he replied. “Maybe buy a bigger sailboat.”

Good answers, as the game show hosts like to say, but not what we were looking for.

“I meant to ask where you would hold your money until you need to spend it,” I responded. “In a savings account? Under your mattress? Mattresses are actually paying competitive returns on cash lately.”

If you believe “Safe Withdrawal Rate” (SWR) advocates, then you probably assume you might be able to spend about 4-½% of your retirement nest egg each year and have a 94% probability of your savings lasting 30 years or more1

I don’t believe this for an instant, mind you. The so-called SWR analysis is fatally flawed, but I think it can serve as a comparison of the alternatives.

Using the same data, the analysis shows that if you hold your retirement savings in money market accounts, you have only a 31% chance of your money lasting 30 years or more with a 4-½% annual spending rate.

I have no confidence that a retiree today could invest in a 60/40 stock portfolio, spend 4-½% annually and remain solvent for thirty years, but I might be convinced that socking savings away in a money market account would be roughly three times worse.

SWR believers would say my friend could lower his spending rate to about 2.8% a year and get close to that 94% survivability rate. With a million dollar portfolio then, my friend could spend $45,000 a year if he stays in stocks, but only $28,000 a year if he “cashes out”. Of course, this is in addition to the income he and his wife will receive from Social Security benefits, so either way they’re better off than 95% of the retiring U.S. workforce in 2013.

Another alternative would be for my friend to sell his portfolio and buy a lifetime fixed annuity from an insurance company, but the last time I looked they were only paying around 3.5% annually for an inflation-protected annuity. If he were worried about market risk, that might be a reasonable thing to do, but he’d still have to worry about the financial health of the insurer.

Furthermore, the sweet spot for annuities is around age 70, so he might be better off staying in stocks for a few more years until he can get a better deal. Maybe interest rates will rise by then, helping even more.

So, you can’t just “cash out” your stock portfolio and declare victory on the day you retire. You may have made it through the accumulation phase with enough savings to maintain your standard of living in retirement, but in many ways the spending phase is tougher. You have to make that portfolio last for the rest of your life.

You might be able to do that with a portfolio of stocks and bonds, or by purchasing a lifetime annuity, but it will be nearly impossible to achieve with cash alone.

While “cashing out” your portfolio when you retire is probably a poor strategy, reducing your risk is not. A bear market just before or just after retirement can destroy your retirement plans, as many retirees learned in the 2007-2008 stock market and real estate crash. That means lowering your stock allocation to somewhere around 40% to 50%, in my opinion, and that’s probably what my friend should do, if he hasn't already.

According to William Bernstein's The Intelligent Asset Allocator, an 80% stock portfolio would probably suffer a decline of no more than 35% in a bad bear market, while a 40% stock portfolio should lose no more than 15%.

I typically cover topics that might help retirees who haven’t saved enough and this one obviously applies to people with significant retirement savings. The transition period just before and after retirement is very interesting for those with large portfolios, though, so I will digress a bit over my next few blogs to discuss that topic.

My point today, however, is that your investment challenges don’t end the day you retire. In fact, they become more difficult. Not only do you no longer have income from work, you're spending down your portfolio and you may need to take less risk with your investments, which more often than not means lower returns.

You'll need more help solving that problem than you're going to get from cash.


1Safe Withdrawal Rate calculations are based on the spreadsheet provided by The Retire Early Homepage.

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