Being wealthy doesn't mean having all the money in the world, just not having to worry about it.

Lesson 6 – The Real Meaning of Safety

There are some people who believe that a retiree’s portfolio should consist primarily of “safe” investments. In this context, safe generally means low volatility. If, for example, you keep all your money in a federally insured bank account, then it will never have a day when it goes down in value. There are, however, two major problems. First, it will also barely go up in value. Second, after considering increases in your cost of living and the taxes owed on the interest, it is not only possible but virtually certain that your account will go down in terms of its real value, meaning its ability to purchase goods and services. And since you’re planning to draw money from that account in order to pay for those goods and services, you’re likely to go broke eventually unless you’re extremely wealthy or are lucky enough to die quickly.

The point is that new retirees are still long-term investors. That 65-year-old couple in San Diego has a joint life expectancy of more than a quarter-century, meaning at least one of them can be expected to live into their nineties. And while we’ve been assuming up to this point that there are no heirs, most people do want to leave a legacy to their children or favorite charities. This, of course, is why the annuities discussed in the previous two lessons are not appropriate for most retirees.

The most important risk, then, is the risk of out-living your assets or of unnecessarily disinheriting your children and grandchildren by earning low, or even negative, real returns. Safe investments are not safe.

So as much as we might want to avoid volatility in our investments, we should be more focused on obtaining reasonable returns in exchange for not trying to avoid all of it. Historically, the highest rate of return has come from equity investments in the businesses that have provided the world’s goods and services. Over the course of the 20th century that figure was around 6% per year above the rate of inflation, before income taxes. Government bonds and similar safe investments, by comparison, returned only 1% above inflation over that 100-year time span. It is difficult to estimate the damage from taxation, but it’s reasonable to subtract 1% from both figures, leaving equities at 5% above inflation and government-guaranteed investments just treading water. If you’re wondering why we’re not taking more out of the higher returning equities, keep in mind that they have historically received extremely favorable tax treatment, including special capital-gains rates, postponement of taxation until gains are realized, and a stepped-up basis (known affectionately as the Angel of Death tax benefit), wiping out the entire taxable gain if shares are not sold during the taxpayer’s lifetime.

In theory, a retiree who kept all his investments in equities and took out 5% of the value at the end of each year would have maintained his real wealth indefinitely for himself and his heirs. Of course, this ignores the fact that 5% is only a long-term average. The global stock market has periodically suffered 50% cumulative declines. A withdrawal that represented 5% of the value at the market peak would be 10% of the value of the subsequent bottom. While most people are happy to increase their spending massively during big bull markets, few are prepared to cut their withdrawals in half during deep bear markets. A more realistic approach might be to draw out only 4% of the value in up years while repeating the previous year’s withdrawal amount during down years.

But while rejecting the false security of government-guaranteed investments, does it really make sense for a retiree to keep 100% in equities? We’ll discuss that in our next lesson.