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Welcome to How to Retire on Time, a show that answers your retirement questions. Say goodbye to the oversimplified advice you've heard hundreds of times. This show is about getting into the nitty-gritty so you can make better decisions as you prepare for retirement. Text your questions to 913-363-1234 and we'll feature them on the show. Don't forget to grab a copy of the book, How to Retire on Time, or check out our resources by going to www.retireontime.com.
Welcome to How to Retire On Time, a show that answers your questions about all things retirement. My name is Mike Decker. I'm a licensed financial adviser who can even file your taxes. Now that said, please remember this is just to show I'm not giving you financial advice. Everything you hear should be considered, well, informational.
Mike:With me is my esteemed colleague, mister David Franson. David, thanks for being here.
David:Yep. Glad to be here.
Mike:David's gonna read your questions, and I'm gonna do my best to answer them. You can text your questions in right now to (913) 363-1234. That number one more time. (913) 363-1234. Let's dive in.
David:Hey, Mike. How can an annuity offer a guaranteed withdrawal rate of six and a half percent when we are told you should only take out 4% from your portfolio?
Mike:This is like stepping into a Viper's nest or something. What a loaded question. So it's loaded on a couple of levels. First off, the 4% rule is a rule of thumb. It's not exactly what a withdrawal rate is.
Mike:And if you go to the financial conferences, which I'm sure everyone here is just gearing up. You know, you got the Met Gala. You got the Grammys, and you have the local financial conference. Right? Equal excitement.
David:Absolutely. Lots of paparazzi at those financial conferences.
Mike:It's a very highly debated topic of what the correct withdrawal rate is. Now that said, the insurance company is not a charity. They're not smarter than the whole industry of the broker dealers, the hedge fund managers. So the whole quest it's like saying, why do apples not taste like oranges? So let's slow this down and really pick it apart step by step.
Mike:Sounds good. Which one do you wanna start with? The 4% rule or the 6.5% withdrawal rate?
David:Let's start out with that rule of thumb, 4% rule.
Mike:K. So the 4% rule, which was invented by William Bengen and is a well tested, documented, peer reviewed concept that says if you invest in a sixty forty stock bond fund portfolio, which I'm not saying you should do, I'm just saying that's kind of what the study was built around, that your stock should average 9% year over year, should. Doesn't always. And then your bond funds, I'd say four or 5%, I think, would be reasonable over a long term study here that you should be able to draw 4% and be fine. Now the idea was, and I'm paraphrasing here, that markets go up and down, and that and that's expected.
Mike:But if you're drawing less than it's growing, then you should be able to withstand some of the market crashes. Should is the keyword here. It should give you a good idea of how much you need to save. Should again being the keyword here. Should give you a realistic income target, should being the keyword Noticing a theme there.
Mike:Yeah. Some repetition will do us all well, but it was a rule of thumb. The problem with the 4% rule is something called sequence of returns risk.
David:Explain that.
Mike:Yeah. So sequence of returns risk, the idea is that the sequence of the return matters. So when you're investing in the market, when the markets go down, it's to your advantage. Anyone that's 50 years or younger should want the markets to tank, to just be mayhem.
David:Okay.
Mike:So they can buy into it cheaper, and then it recovers.
David:Okay.
Mike:It's like, you know, everything goes on sale. It's not like a business is putting everything on sale saying, yeah, let's make less money. There's a reason why businesses do sell anyway. So that's called dollar cost averaging. It's to your advantage.
Mike:But when the flow of money reverses, it's not dollar cost averaging. It's called sequence of returns risk. So here's why. If you draw income from an account that's made money, it's not that big of a deal. But if you draw income from an account that's lost money, it is a big deal.
Mike:You're accentuating the loss, making it more difficult to recover. Here's the simple math. If you lose 10% in your accounts, it takes 11% of growth to break even, not the end of the world. If you lose 30% in your accounts, which historically happens every seven or eight years, that would take a 43% return to break even. Now if you lose 30%, and you take out 4%, because that's the 4% rule, you need to pay your bills, you need to live your life, you're now down 34%.
Mike:That means you would need a 50% return to break even. That could take four or five years. No one knows the future. So you can see where this timing the market, the sequence of the return matters. Oh, well, Mike, it's okay.
Mike:Overall, the average is 6%. Averages are deceptive. And this is why it's meant to be a rule of thumb, not an actual withdrawal strategy.
David:Sure.
Mike:So averages are deceptive because let's say you expect a 10% average.
David:Okay.
Mike:So a hundred thousand dollars with a 10% average over the first year, you'd have a hundred and $10,000. In the second year, you'd have a hundred and $21,000. You see how it progressed their 10% growth each year on Well, let's say the markets went down 30% year one, your hundred thousand is now 70,000. But let's say then the markets recovered, and let's say they really recovered fast. Let's say they had a 50% return.
Mike:Oh, yeah. Okay, now it's a 10% average, which I can't remember any time that's ever happened, but for argument's sake, let's say it did happen. You would now be up at a hundred and 5,000 with your cash value, 10% average, but really the return on your cash is what? Two and a half percent year over year, very different. So when you're looking at your withdrawal rate, withdrawal strategy, taking money out of accounts that has lost money, accentuates the loss, making it more difficult to recover.
Mike:That's why sequence of return risk is a big deal. So the idea behind the 4% rule is you can focus on growth, you can have flexibility, but you just gotta understand that if the markets go down, you might need to tighten things up. It could be difficult. You're basically trying to time the market, health care costs, whatever reason you'd need to spend your money. Right?
Mike:Right. And hope that it's not during a market crash, or hope that your market crash is when you retire is like seven, eight, nine years away from when you retired, so you had enough growth to then handle it. But if the markets crashed the first or second or third year of your retirement, you could be tripping up for the rest of your life. You may never fully recover.
David:Yes. Yes. I gotcha.
Mike:Okay. So that's the 4% rule, and it scares the bejesus out of people. It scares them so much that then people panic, in my opinion, and they'll buy the annuitized income. What's that? That's this promised 6.5%.
Mike:Uh-huh. And from an argument standpoint, would you rather get 4% for the rest of your life or 6.5% in guaranteed? And there's so many manipulative sales pitches, dinner seminars that just go through this over and over again. Let me explain what you're not hearing.
David:Okay. Yeah. We'd love that.
Mike:If all things were equal, and you could guarantee a six and a half percent return for the rest of your life, that's the easy thing to do. It's not. 6.5 from what I have seen, and those rates can change. We're not quoting any specific product here. It's an advertisement that I have seen go around on someone's LinkedIn posts that I'll just leave it there, and my sentiment towards that, but the oversimplification's out there.
Mike:Basically, that's a flat income stream. There's no cost of living adjustment. So you could have 6.5% of your million dollars, and have that income for the rest of your life, but inflation's gonna erode it over time. So if you compare, let's say a 4% income that's growing, and the balance is growing at a reasonable rate adjusted for inflation, and compare the cash value, the spendable income, your buying power, and compare that to a flat income that starts higher, but after ten to twelve years, inflation would have, on average, based on that 3% inflationary rate, eroded to the point where you have less money to spend than the 4% rule. The breakeven is based on my calculations after ten to twelve years.
David:I mean, that doesn't sound like that doesn't sound good, does it?
Mike:When do you want the purchase power squeeze to happen? In your eighties? When you're not going back to work? When your health is declining?
David:Right.
Mike:I mean, it's it's a huge deal. And we forget about these things because for the last, what, Since 02/2010, we've had virtually no inflation, and then all of a sudden it just it spiked. Right. So we need to have more holistic, more comprehensive conversations about what are you actually signing up for. Because six and a half percent flat income, in my opinion, is dangerous if you live a long time.
Mike:And if you don't, probably wasn't that financially advantageous either because the cash value may not have grown that well. So you've got to look at what's under the hood. How is inflation going to erode it? Now let's talk about inflation today. Do you feel some inflation over the past couple of years
David:since the pandemic? We might have noticed a little bit. Yeah. Yeah. Grocery bills a little bit higher, other goods higher
Mike:than they were. Everything's gone up. Yes. So you could say roughly 30% of our money's been inflated away. We really felt it.
Mike:K? Let's go to the annuity for a second. Anyone that would have signed up for a flat income stream, let's say in 2019, just lost 30% of their lifetime income. Wow. Roughly speaking.
Mike:Yeah. Because inflation got out of control and their income was fixed. That's a danger. Now let's look at I'm gonna get political for a second. You mind if I get political?
Mike:Well, it's your show. That's true. No one owns us. We could say whatever we want as long as it's legal, honest, research backed, and ethical, and we can say it. K.
Mike:It's a good standard.
David:Then let's
Mike:do it. So in the late sixties, early seventies, inflation got out of control. They increased interest rates. They made money expensive again, and they brought inflation back down. And they said, oh, inflation's trending down.
Mike:We we fixed it. Then they lowered rates, which they did too soon, and then inflation spiked back up. I mean, over 10% in one year. It it was horrible. And then they they jacked up interest rates because they're trying to make money more expensive to try and hurt the economy because the economy got out of hand, and inflation got out of hand.
Mike:So that's what you do when that happens, and then inflation started coming back down again. They said, alright. Well, we've solved it this time. It's going down fast enough, but we don't wanna hurt our economy too much. So then they lowered interest rates too soon for a second time.
Mike:And then what happens? Inflation got out of control again.
David:Ay ay ay.
Mike:And then one of my economic heroes, Paul Volker, the cigar smoking chairman, got in there, and he cranked up interest rates so high. I mean, where it really hurt the economy. But it's like physical therapy hurt, like the good kind of hurt.
David:I know exactly what you're talking about.
Mike:Go to massage therapist, they give you a deep tissue massage, the good kind of hurt. K? Right. Whether people like it or not, it's what we needed. He brought interest rates back into parity and under control, which led to a very healthy economic boom in the nineties.
Mike:I thank Paul Volcker for that. So all of that said, if you look at those charts and you look at what's going on today, there's a reason why Fed chair Jerome Powell is probably not eager to lower interest rates too soon. Just look at corporate profits. They're at record highs right now. The economy could go gangbusters, especially if he dropped rates.
Mike:And what would happen? High risk of inflation getting out of hand. Now maybe it doesn't. Maybe it does, but I understand why he's holding out on interest rates and why he's keeping things where they are. It's not politics.
Mike:It's history, and I can argue for him. Now should he and other for other arguments? There's a lot of arguments made with economics. That's why it's theoretical, kind of. The point being is inflation can come or could come roaring back if Trump flinches, if the tariffs don't work out as he plans, if Jerome Powell cuts rates too soon, if the dollar weakens too soon, or there are so many re so we are walking along a very thin line here with inflation.
Mike:So if you're signing up for a flat income stream, though it sounds appealing at 6.5%, understand the risk that you're taking. It may work out to your benefit. It may not. Everything has benefits and detriments. There's no such thing as a perfect investment product or strategy.
Mike:Nothing does everything well. And insurance companies are not charities. They're not giving you more money out of the goodness of their heart. That's not to vilify any insurance company. It's that I believe their products are not being properly and correctly defined, identified, and explained to people.
Mike:Right. So we need to understand.
David:Yeah. And then what do you always say about insurance that's not an investment?
Mike:More specifically, life insurance is not investment, but even annuity, you could argue that too because an annuity typically is associated, based on my experience, with an index that's not very competitive. Now there are some annuities that have a competitive cash value growth aspect, but their income stinks. People don't talk to them about them as much. But you've got these annuities that offer competitive growth, but they've baked in when they expect you to pass. The cash value should be done within a reasonable time so that the odds are in the insurance company's favor, and there's nothing wrong with that as long as we correctly define that.
Mike:You have transferred longevity risk to an insurance company. That's what you've done. This idea that you can get a better withdrawal rate, it's not a withdrawal rate. The 4% rule, 4% is growing based on your assets growing. Right.
Mike:There's a cost of living adjustment or provision baked into there to help you keep up with inflation. You can buy an annuity with a cost of living adjustment, so guaranteed income for life, but you're not starting at six and a half percent. You might start at five or 4%. Interesting how we got back to 4% there. Uh-huh.
Mike:You might buy an index income increase so that if the markets go up, your income increases. But again, it's not guaranteed. There's some nuance with that, and what index is it associated with. And when does that benefit stop? Because it typically stops after the cash value hits zero.
Mike:There's more going on here than meets the eye. You need to understand the benefits and the detriments, because the second you think you're getting a good deal or an exception to the rule, there's something you're missing. I cannot emphatically say that enough. I know many people that have purchased a flat income stream and a cost of living adjustment income stream. So based on an index, and that covered their basics.
Mike:So, you know, the basic expenses of life, and then they blended other assets for other income sources, whether it's privately traded REITs, whether it's just income from the growth or a dividend strategy or the rental income. I mean, there there's so many things you could blend in. I could see that making sense in those situations, but all in all, be aware of what you're doing. Ask questions. These things matter.
Mike:That's all the time we've got for the show today. If you enjoyed the show, consider subscribing to it wherever you get your podcast. Just search for how to retire on time. Discover if your portfolio is built to weather flat market cycles or if you're missing tax minimization opportunities that you
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