The simple formula to sustain an early retirement without running out of money.
In this episode, you’ll learn:
- What is the mind the gap formula for early retirement.
- What is a reasonable rate of return to expect from investing during retirement.
- How losing money in the early years of retirement can significantly reduce how long your nest egg will last.
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Mind The Gap
First-time travelers to London often notice the spoken warning, “Mind the gap” when the car doors open on the Tube, the city’s underground railway system.
The “gap” refers to the space between the train car and the station platform that unaware passengers could fall into and twist an ankle or worse.
Personal Finance Gaps
In our financial lives, there are also gaps we should mind.
When leasing or buying a car, gap insurance is a solution that covers the financial gap between what traditional insurance will pay if a car is totaled in an accident and the higher balance that might be owed on a loan or lease.
A far more important financial gap relates to how long an individual’s retirement savings will last.
This gap is the difference between an investor’s annual return on their investment portfolio after inflation (known as the real return) and their annual spending rate.
For example, if a retiree’s total return is 6%, inflation is 3% and the retiree spends 4% of the portfolio value then the gap is -1%.
6% less 3% less 4% equals -1%.
When The Gap Is Zero
When I advised college endowments and private foundations, we structured investment portfolios with an expected gap of zero.
A portfolio with an annual spending rate that is equal to or less than its real (net of inflation) return will continue to grow into perpetuity.
That is how foundations, such as the Ford Foundation and the Rockefeller Foundation, continue to have a financial impact decades after they were originally funded.
When The Gap Is Negative
Most retirees will have insufficient savings to spend less than their annual real rate of return.
Instead, a typical retiree might spend 4% of their investment balance in the first year of retirement and then adjust that spending amount by inflation each year.
If we assume that typical retiree earns 6% per year and inflation is 3% per year, then a 4% spending rate equates to a gap of -1% in the first year of retirement, similar to the example above.
But, given the spending amount increases by the rate of inflation each year, the gap also increases each year.
By the tenth year, the retiree’s spending rate as a percent of their portfolio balance is 4.6%, which equates to a gap of -1.6%, assuming a portfolio return of 6% and inflation of 3%.
If the assumptions for return, inflation and spending hold, in the 21st year of retirement, the retiree’s spending rate reaches 6%.
At the point, the portfolio value is at its highest amount on a nominal basis and then begins to decline because the annual spending rate will be greater than the portfolio’s rate of return.
If the retiree continues to increase the spending amount by inflation and earns 6% per year while inflation stays at 3%, the portfolio will be depleted in the 42nd year of retirement.
How long would the portfolio last if we keep all the assumptions the same except the portfolio earns 5% annually instead of 6%?
In that case, the portfolio would last 33 years before being depleted.
Return Sequence Risk
While these are helpful examples to understand the financial concept, the reality is rates of return are not the same every year. Nor is inflation.
The sequence of annual portfolio returns has a significant impact on the retirement outcome.
For example, a retiree that loses 10% per year in the first two years of retirement, and then earns 7.2% per year, will deplete their assets in 30 years, even though the annualized return over that time frame is 6%, the same as our earlier example.
The portfolio would be depleted in 30 years instead of 42 years because the gap in the first two years of retirement was -17%.
The takeaway is large negative losses in the early years of retirement can have catastrophic retirement consequences.
A prudent retirement approach is to invest conservatively so that the variability of returns is low in order to avoid large negative gaps.
While most retirees’ annual spending rate will be more than they earn on their portfolio net of inflation, if that gap is consistently small during the first decade of retirement, even though it is negative, there is a much greater likelihood the retirement nest egg will last 35 to 40 years or more.