In the world of electric car development, there is the phenomenon known as "range anxiety" that refers to the 75-mile range of the 90's-era General Motors electric car --- the car that "they" killed (by crushing) after allegedly realizing that nothing ever broke. The fundamental problem with this car, according to the urban myth, is that its popularity would have put General Motors dealers' service departments out of business.
The real killer, however, was that dreaded "range anxiety" --- the paranoia of being totally helpless and alone on a dark night with a dead battery by the side of a lonely road. A friend of mine had one of these cars for the trial period (they were never sold; only leased by GM,) and for his wife's sake, I always offered to follow him home after dinner parties in case he ran out of juice.
The term "range anxiety" could just as easily apply to the probability of running out of money during retirement. Different studies approach the problem from a variety of vantage points. No matter how you view it, the news is not good for many retirees, and bad news is a set-up for the sale of expensive investment products that are doomed to fall short of expectations.
One of the most instructive studies was published in the February 1998 AAII Journal (Association of Individual Investors.) It has been condensed and updated in the July, 2008 issue. The study compared withdrawal rates of between 4 percent and 10 percent per year over periods ranging from 15 years to 30 years. Then, with sliding-scale combinations of stocks and bonds (100 percent stocks to 100 percent bonds) the study determined the probability of running out of money based on historical past periods of rolling 15 to 30-year periods --- from 1926 through 1995.
In previous columns, I have suggested the advisability of a 50/50 mix of stocks and bonds for retirees in the early years of retirement. The thought was that the bond half would generate about 6 percent interest and value-oriented stocks would generate 2 percent in dividends for a total portfolio return of about 4 percent without eating into the principal at all. The stocks making up half the money would also appreciate at rates about twice the rate of inflation, bringing the total portfolio's appreciation to an average of roughly the rate of inflation. As Ross Perot would have said, "It's that simple."
The AAII study showed that my approach would have had a 100 percent chance of not running out of money over 25 years and that there was a 5 percent chance that the portfolio could run out of money if the retiree lived for 30 years.
The reason for the possibility of running out of money, in spite of what looks on paper to be a sure thing, is that some historical 30-year periods had big stock market losses in the early years while funds were being drawn from the portfolio. Those early year losses create a situation where, in 5 percent of those 30-year periods, the money would have been exhausted. A 5 percent risk of running out of money seems like a reasonable risk for most people --- especially if they have other non-invested assets like home equity to fall back on toward the end of 30 years. Moreover, what are odds of living to 95?
Next is the tantalizing thought of increasing the extraction rate to, for example, 6 percent. The model shows that at this annual rate, there is a 49 percent chance that the retirement plan will run out of money by the 30-year mark. There is a 75 percent chance of making it for 20 years, however, before going broke.
The good news is that the average person retiring at age 65, has only a 50 percent chance of living 20 years. Therefore, to calculate the odds of having the 25 percent problem mentioned above, we multiply by the odds of getting there. Fifty percent times 25 percent gives us a 12.5 percent chance of ever having to go live with the kids.
When we see the difference in potential "range anxiety" between an extraction rate of 4 percent and one of 6 percent, it's important to realize that, in many cases, the extra 2 percent doesn't get to the retiree as income. It sticks to the fly paper of some financial institutions in the form of fees and commissions. We need to be informed and circumspect, or we'll enjoy just 4 percent income while harboring that "range anxiety" of a 6 percent extraction rate.