The Flawed Accumulation-Deaccumulation Model of Retirement Planning
An article published last week represents what is likely the most widespread highly flawed conventional wisdom assumptions about retirement financial planning which is the “accumulation-deaccumulation” model.
The question commonly asked is “how much money do you need to retire?” A commercial on TV a few years ago asked “what is your number?” and featured people carrying around large orange numbers on their shoulders ranging from about $500,000 to about $2 million.
The dangerous accumulation-deaccumulation model assumes that you should accumulate a massive pile of money by trading stocks, bonds and other paper assets that can be bought and sold with the click of a mouse that generate commissions and administrative fees for large brokerage houses that have marble floors in their waiting rooms. Then when you retire, you are supposed to sell the paper assets (generating more commissions) at a rate (which used to be 4%) that will deplete the pile of money in such a manner that you will be able to buy food and medicine until you die after subtracting the amount of passive income you get from Social Security and/or the rare pension plan.
The accumulation-deaccumulation model also makes some ridiculous and dangerous assumptions such as that you should rely on a certain return for your investment portfolio, which is 8% per year at the brokerage house where I keep my limited portfolio of mutual funds. I wrote a blog article earlier this year dedicated to the dangers of that absurd assumption.
The actual performance of the S&P 500 over the past 20 years from 1999 to 2018 gave a non-impressive compounded return of 3.7%. If you don’t believe this number you can verify it for yourself.
In any case, articles such as these have the majority of the sheeple believing that the most important component of retirement planning is hitting the magic number for net worth, held in liquidatable assets (i.e., that you can access funds within 48 hours of a clock of a mouse), that you can spend down to meet your needs in retirement.
The fine print in many of these articles mentions the actuarial average age at which you should plan to die. I always wondered if they want you to die at that age or pray that your nest egg will somehow last longer if you last longer. But that is not the biggest flaw in the accumulation-deaccumulation model. Even inflation is not the biggest flaw in this model. Even the ridiculous assumption that you only need 70% of your pre-retirement income after you leave your job, is not the biggest flaw in this model.
The biggest flaw in the accumulation-deaccumulation model is that it relies on the assumption that you should plan to pay the balance of your daily living expenses after Social Security payments, from a large pile of cash that you must accumulate.
Let’s consider two hypothetical scenarios.
The first scenario will be based on the following assumptions:
A couple has one wage earner who starts at $30,000 per year at age 30
The wage earner’s salary increases by 3% per year and by age 65, the income is $84,400 (median household income in 2018 was $61,800)
The couple puts away 7.6% of their gross income every year into retirement savings (personal savings rate in the US during 2015-2019 ranged from 6.5% to 8.8% according to FRED = Federal Reserve Bank of St. Louis)
The compounded return on the investment of retirement savings is 5% (compare that to the 3.7% compounded return on the S&P 500 for the 20 years of 1999-2018). Under these assumptions, at age 65 the couple will have retirement savings of $329,900. The average retirement savings of Americans in their 60’s is $172,000 (this one data point already shows that Americans have major problems saving for retirement!).
The couple will spend 70% of their pre-retirement income after retirement (this is a common assumption…incorrect, but common)
The couple will receive $1,600 per month in Social Security payments starting at age 65 at which time the working spouse retires.
Inflation is intentionally ignored in this graph
The red curve in the graph shows the accumulation of retirement savings from age 30 through age 65 and the deaccumulation of retirement savings using the assumptions shown above.
The graph shows that the couple has nothing left at age 76!
I certainly hope that your numbers are MUCH better. They are, aren’t they?
Of course, we could manipulate the assumptions and make the numbers come out such that the couple never runs out of money. But it is very risky to rely on aggressive assumptions since if they do not come to fruition, the couple may find themselves in unacceptable financial hardship with little opportunity to make extra money in their 80’s and 90’s. Are you willing to bet your entire financial life on aggressive assumptions?
Since it is so easy to manipulate the graph with different assumptions, let’s take a look at the same exact scenario as in the graph above, but with one change. We will change the rate of compounded returns on investment of the retirement savings from 5% to 8%. This is the rate of return used by the brokerage house in which I hold mutual funds in my traditional IRA.
The green line in the graph shows the very impressive performance when changing that one assumption from the compounded return of 5% to 8%. The results are totally opposite! This situation is totally viable!
What have we learned from this mental exercise?
We learned that your financial viability is EXTREMELY sensitive to the assumptions you make, so you better be EXTREMELY careful about which assumptions you consider including in your plan and with what numbers. The difference in just one number (5% vs 8%) can make the difference between bankruptcy and living in luxury!
Commendably, the article does recommend starting with the extremely important task of estimating your daily living expenses. This indeed is crucial. I recommended this in an earlier blog article.
Now let’s look at an oversimplified scenario that does not require a spreadsheet.
Let’s say that you and your spouse need $5,000 per month of after-tax money to cover your ROUTINE daily living expenses while you’re still living at home. This does NOT include SPECIAL expenses such as long term home care, assisted living, special medical expenses, going on cruises, down payment for a car while you still can drive, wedding gifts for grandchildren getting married, etc. Those SPECIAL expenses are different than your ROUTINE expenses and may be best covered by the liquid portion of your net worth that you should be accumulating.
Right now, we are talking about covering your ROUTINE daily living expenses for the rest of your life.
Let’s also assume that both you and your spouse get the average Social Security payment which today is very roughly $1,400 per month per person. That gives you $2,800 per month. Of course, that is before tax since the federal government taxes you on Social Security income and so do many states.
If you don’t have a pension from your employer, then this hypothetical couple needs about $2,500 per month of additional income to survive assuming no medical catastrophe (Medicare covers 80% of covered costs), no assisted living needs and no cruises to Alaska.
The first key to retirement is covering ROUTINE expenses on a monthly basis. So, the first key to retirement should be PASSIVE income on a monthly basis to cover those predictable and unavoidable monthly expenses.
If this couple can generate PASSIVE income to cover the difference between their known and predictable ROUTINE monthly expenses and their predictable Social Security payments, then in theory, that PASSIVE income can cover the difference between the ROUTINE monthly expenses and the monthly Social Security payments, WITHOUT TOUCHING A PENNY OF THE NEST EGG.
When you think about it, the Social Security payments are themselves a source of PASSIVE income.
The FIRST key to retirement is PASSIVE income, NOT retirement savings or net worth.
Don’t get me wrong, net worth is very important (#2 on my list) and even crucial as we will see below, but not as important as PASSIVE income if you actually survive into your 90’s, which many of us do. Imagine surviving physically into your 90’s but not surviving financially into your 90’s!
People would be better off focusing in their pre-retirement years on generating sources of PASSIVE income in retirement, as opposed to exclusively focusing for decades on “saving” for their nest egg under the accumulation-deaccumulation model.
There are MANY ways to generate PASSIVE income, but the financially illiterate general population is rarely exposed to proper education on these PASSIVE income vehicles. They include investments such as rental real estate that is managed by others, note investing, whole life insurance policies and others. Many of these investment vehicles (including real estate and note investing though not life insurance) can be invested using self-directed IRA funds (I invest in them using self-directed 401k and Roth 401k funds).
I have been teaching for years (and practice what I preach) how to cover ROUTINE expenses from PASSIVE income, cover SPECIAL expenses from the liquid portion of NET WORTH, and use insurance for the rest, such as the best Medicare supplemental insurance you can get in your state and long term care insurance that covers a high fraction of home care, skilled care (nursing home) and hospice costs.
Relying solely on a pile of cash for all ROUTINE expenses and SPECIAL expenses and catastrophic expenses is an extremely risky strategy. If this strategy breaks down when you are 89 years old and you have another 6 years to live, your life becomes a financial living hell. If you run out of money in your 70’s heaven forbid (which is most people’s situation when they sit down and do the math), you can find yourself in untenable quicksand made of pure sheepdip.
Fortunately, you can use your self-directed retirement plans (pre-tax and Roth), like I do (mostly Roth) to generate tax-free (Roth) and tax-deferred (pre-tax) PASSIVE income to use in retirement to supplement Social Security payments to cover ROUTINE household expenses. Then you can estimate how much liquid portion of your net worth you need to cover SPECIAL expenses.
The reality is that most people believe that the accumulation-deaccumulation model is the right way to plan retirement. The further reality is that most people who believe this flawed model, don’t even meet the requirements of that model!!!
Have you done your calculations?
Are you prepared?
Do you have a self-directed retirement plan? Does it generate PASSIVE income?
I have done all of this and I am prepared.
But you are not me.
You are responsible for you.