Living off Retirement Savings in a World of Uncertain Return Patterns


A “conservative” approach doesn’t necessarily need to translate into more conservative investments in your portfolio during your retirement years.

Look in almost any financial publication or informational brochure aimed at individual investors and you will find broad asset allocation recommendations for the various stages of one’s life.

Most of these recommendations are based on similar investor characteristics at each particular stage in life. While the actual recommendations vary, most follow similar profiles over time. And in general, most assume that retirees become more conservative.

Why the general assumption that retirees become more conservative and risk tolerance decreases? Do one’s risk cells gradually die off as one ages?

As most retirees quickly discover, the concern has less to do with any perceived psychological changes and more to do with the problem of periodical withdrawals and the subsequent gradual shrinking of a portfolio.

But there is more than one way of being conservative, and an understanding of this concern might help you in your own asset allocation process and in the assumptions you are using to determine how much to withdraw each year in retirement.

The Reasons for a Conservative Outlook

Withdrawing from a portfolio produces a more conservative outlook for several reasons, depending on the type of withdrawal plan or “spending rule” that you adopt.

There are several common rules of thumb that are used by many retirees to determine how much of their savings to spend each year. They include:

  • Spend only the income generated from investments;
  • Spend the total annual rate of return from investments;
  • Create your own annuity and spend at a rate that allows you to withdraw a fixed amount consisting of both principal (your original savings) plus earnings on your savings over a fixed time period. (Of course, you could also buy a commercial annuity from an insurance company that would reduce the risk of a miscalculation, assuming the insurance company remains intact, but you will pay a price for this “insurance.” This article assumes you are taking the do-it-yourself approach.)

It’s easy to see why the first rule of thumb results in a more conservative investment approach. This rule encourages retirees to maximize income by putting savings in higher-yielding investments, such as bonds, and avoiding lower-yielding, higher-risk (but also higher-growth) investments such as stocks. The significant downside to this approach is that over the long term, your savings—and the income it generates—is unable to grow enough to keep pace with inflation, and you eventually may be faced with a lower standard of living down the road.

The second rule encourages retirees to invest in more growth-oriented vehicles to protect against a loss in purchasing power since the return can consist of either capital gains or income from interest or dividends. However, single-year returns can be volatile, and most retirees would prefer a steadier income source. Thus, it is easy to see why this rule, too, would result in a more conservative investment approach.

The third approach, and variations of it, encourages retirees to invest in more growth-oriented vehicles; it also smooths annual withdrawals for a steadier source of income and it allows retirees to dip into part of their initial savings—a need for many who don’t have enough wealth saved up to live off only income or returns.

However, retirees need to adopt a conservative outlook when using this third approach, although that outlook does not necessarily need to translate into more conservative investments. To see why, let’s first review the approach.

Spending Rates: The Annuitization Approach

This spending rate approach annuitizes your savings based on your life expectancy, the rate of return you expect to earn over the time period, and the amount of money you want remaining at the end. Annuitization means to spread a lump-sum amount into equal withdrawals over the given time period, taking into consideration all of the earnings that will be generated by the remaining savings as they are gradually paid out. Under full annuitization, no savings remain at the end of the time period. However, you can adapt the approach to have various percentages of savings remain at the end to pass on to heirs or as a hedge against unknown life spans. If you choose to have 100% of savings remain, you essentially have chosen an approach that withdraws (spends) the long-term expected annual return on the portfolio.

One other adaptation is to take inflation into consideration so that the annual withdrawals increase at the expected rate of inflation. Under this approach, a “spending rate” is established for the first year—a percentage of your savings that you can spend; in subsequent years, the initial dollar amount can be increased by the assumed rate of inflation. Table 1 provides an example of the approach, and indicates the first-year spending rates for various life expectancies and rates of return, assuming a 4% annual increase in inflation and assuming that all savings are used up at the end—in other words, no estate remaining. While inflation has averaged around 2.2% a year since 2000, 4% is closer to the long-term historical average for the United States.

Table 1.

The Problem of Periodic Withdrawals

Whatever variation of the annuitization approach you use, the ultimate annual withdrawals will be a function of the expected long-term rate of return on your savings. Annuity equations assume that these long-term average returns are earned every year. Needless to say, this does not mesh with the real world. In reality, your annual returns will vary widely. Does this variation matter?

In the absence of additions or withdrawals to a portfolio, the end result would be the same regardless of when returns are earned. That is, two portfolios with the same long-term average return could have very different annual return patterns, one earning high returns in the early years and low returns in the latter years and the other with the exact same returns but in the opposite sequence, yet they will both end up with the same dollar amount. This is illustrated in Table 2; Portfolios A and B each start out with $1,000 and have the same long-term average annual returns, but opposite return sequences. However, their ending amounts are identical.

Table 2.

If you are making withdrawals from a portfolio, however, it does matter when you earn varying returns. Specifically, your ending amount will be much higher if you earn the higher returns in the early years when there is more money in the portfolio; conversely, if there are too many losses in the early years, you could run through your portfolio much sooner than expected. Table 3 shows the exact same portfolio returns as Table 2, but with annual withdrawals (at the beginning of the year) of $50. Portfolio B ends up the winner after 10 years, with $1,176.26, compared to Portfolio A with only $1,023.28.


Unfortunately, this uncertainty is something every investor must live with, since there is obviously no way to predict returns—much less their sequence—in advance. What’s the best way to cope if you are living off your investments?

Clearly, a retiree would be better off if the returns were less variable—but not necessarily if this is at the expense of a lower long-term average rate of return.

For instance, let’s look at Table 4, which is a “spending spreadsheet” for a retiree who ends up with a very unfortunate return sequence.


Initially, this aggressive retiree decided to put all of his $800,000 retirement savings in S&P 500 stocks, and he assumed a 10% long-term average rate of return on his investment. He also wanted a 4% increase in his spending amount each year to keep up with inflation, and he intended to spend his entire savings by the end of his life expectancy in 30 years. Theoretically, using the annuity spending rate approach illustrated in Table 1, he could spend $53,600 (6.7% of his savings) in the first year, and then increase that amount by 4% each year. If his savings earned 10% each year, he would run through his money in 30 years.

As it turned out, however, our retiree did earn an average of 10%, but most of his big gains didn’t occur until the end of his life expectancy, while the losses occurred toward the beginning. If our retiree continued to withdraw his original inflation-adjusted amount, he would run through his money in only 16 years, as shown in Table 4 under the 100% Stock Portfolio column of the first spending rate example.

Would the addition of lower-return, lower-volatility investments that smooth the return patterns have helped?

The 50% Stock/Bond Portfolio column indicates the results for a portfolio equally balanced between stocks and short-term bonds (assuming rebalancing each year, and assuming short-term bonds return a constant 4%). The result—he still runs out in 16 years in this bad-luck scenario. Although the losses are lessened, so are any gains.

Changing Other Variables

Of course, in the 50% Stock/Bond Portfolio example, the annual withdrawals remain at the rate that was determined based on the assumed 10% long-term average rate of return. However, this mixed portfolio obviously would have a lower long-term average rate of return—probably close to 7% [(50% × 10%) + (50% × 4%)]. If withdrawals were based on this return (with a first-year spending rate of around 5%), our retiree’s savings in this bad-luck scenario would last 24 years, as indicated in the 50% Stock/Bond Portfolio column in the second spending rate example in Table 4.

On the other hand, if withdrawals were reduced in the 100% stock portfolio, our retiree’s savings would also last longer. If he withdrew at the same low rate as in the mixed portfolio, his savings would last 29 years (see Table 4) in the bad-luck scenario, since the higher returns at the end would start to benefit our aggressive retiree.

Of course, this is only one example; there are countless variations on return patterns, and under other scenarios, the mixed portfolio may last somewhat longer than the more aggressive portfolio. The point, however, is that lowering the spending amount is a more certain way to deal with the uncertainty of varying return patterns, and you can do this regardless of whether or not you change your asset allocation to a less volatile but lower-return mix.

Our retiree also assumed that he would be spending his entire savings—he would leave no estate to his heirs. If he had assumed he would be leaving an estate, his annual withdrawals would have been lower, but in the bad-luck scenario, there would be nothing left for the heirs. Clearly, allowing the size of your estate to vary is another way to deal with the uncertainty of varying return patterns. (Actually, since leaving an estate results in lower spending rates, it essentially is the same as lowering your spending level.)

The Conservative Approach

Your asset allocation should be based on your own tolerance for risk, based on the amount of loss you can stomach without abandoning your plan. But this doesn’t need to change when you retire—there are other ways to be “conservative” when you are living off your retirement income.

Here are some things to keep in mind when trying to cope with uncertainty when withdrawing from savings:

  • Make sure you use conservative return assumptions when determining how much to withdraw each year. Using conservative assumptions does not necessarily mean that you should invest conservatively, but don’t assume you are actually going to attain high rates of return with volatile investments when deciding how much to withdraw each year. It is easier to loosen your belt in future years than it is to tighten your belt.
  • Diversification across various investment classes—large-company stocks, small-company stocks and international stocks—that do well at different times tends to smooth returns without significantly lowering long-term average rates of return. Make sure that even in retirement your portfolio is diversified.
  • Don’t give yourself an automatic inflation raise each year just because that is part of your assumption. Increase spending or withdrawal according to real increases in expenses.
  • Make sure you build in life expectancy assumptions that are well beyond what you really expect.
  • Review your circumstances annually to make sure that your assumptions are in line with reality.

This is an updated and edited version of an article written by Maria Crawford Scott for the August 1996 issue of the AAII Journal. At the time, Maria was editor of the AAII Journal.



1 Reply to “Living off Retirement Savings in a World of Uncertain Return Patterns”

  1. Pingback: AAII Blog

Leave a Reply

Your email address will not be published. Required fields are marked *