Troy Sharpe: You’re 59 with $1.1 million and you want to retire in 3 years. The questions are, can you retire and how much can you spend? We’re going to give you a sneak peek how we go through the process with prospective clients here at Oak Harvest Financial Group to help answer those questions. Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, Certified Financial Planner professional, host to The Retirement Income Show, and also a certified tax specialist.
When we start exploring the questions like, can you retire? When can you retire? How much income can you spend in retirement? If something happens to you, will your spouse be okay? When we start to really look at these questions, even though everyone’s situation is different, there are a few key things that we really need to hone in on, and I’m going to focus on those in this video to help answer the questions but also help you understand what those key things that we need to focus on what they are.
First and foremost, there’s a concept called risk capacity and then risk tolerance which you’re probably familiar with. It’s not just risk tolerance it’s important, how much volatility you can withstand, but also your portfolio’s capacity to take on risk in order to generate the income that you need to sustain your quality of life. Now, in addition to that, we need to actually check how your portfolio is currently constructed. If you think about guardrails and your risk tolerance or your willingness to withstand volatility are these guardrails, how is your portfolio currently constructed?
Ideally, we want the most likely outcome, probability-wise speaking, to tap up against this upper guardrail and then the least desired outcome to tap up against this other guardrail. If we can build a portfolio that has an expected return that’s up here for a given level of risk, now we’ve optimized that risk-reward payoff, then we have to determine, is that enough expected return for the level of risk you’re willing to take to generate the income you need to support your lifestyle in retirement? One of the big mistakes that people who invest their own money make in retirement is they’re focused on the return aspect.
Now, you need a certain level of return in order to achieve your retirement goals but the key question you should be focused on or managing is what level of risk am I taking on to obtain that certain required return. If I were to give you an example, two portfolios, let’s say they both earned 20% last year. Which one would you take? Well, many of you are probably thinking, “Troy, they both did 20%, what’s the difference?” What if I told you portfolio A the return 20% had a 50% chance of total and complete loss, meaning you could have lost everything, but then portfolio B had a 10% chance of total and complete loss.
Now, for both of those portfolios that return 20%, which one would you choose? Of course, you choose the one that had the least amount of risk and that’s what our job in retirement is when we’re managing investments for clients, it’s not necessarily about outperforming the S and P or trying to get the highest investment return possible. It’s how do we capture most of the market return for the given level of risk, your plan, your portfolio, your retirement needs or requires.
If you like this video, make sure to subscribe to the channel at no cost, and of course, if you know someone who could benefit from this video, please share it with them so we can help others stay more connected to their money. As we dive into this case study, we’re going to look at hypothetical spending levels and we’re going to increase or decrease those to show the impact on the overall plan but we’re also going to look at the current portfolio construction compared to the risk profile of this hypothetical client.
That’s going to cover the risk willingness or risk tolerance, the risk capacity of the portfolio, and finally, we’re going to look at the sequence of returns risk or what we call bad timing risk. If you retire in this example and then the market is down, that year and then the subsequent year, how does that impact your portfolio? We’re going to briefly talk about average rates of return and how you could have 10 different portfolios that average the same rate of return but end up in 10 completely different outcomes.
The initial spending level that we’re looking at is a $60,000 base spending level, so right now, we’re in 2022. This couple is 59. They want to retire in 2025 so 3 years down the road at age 62. Go Go Spending. This is the additional spending when you’re young, healthy, and active that you want to spend above and beyond that base spending level. Now, you may not spend $25,000 every single year. One year, it might be 30 or 35, and then the next year, it might be 15 or 20.
It’s just an average spending level and the most important thing when it comes to this type of analysis or planning is knowing that the real world is different so this isn’t something that we do once and set it and forget it and you’re good to go. This is an ongoing conversation and a relationship and when we talk about the retirement success plan here at Oak Harvest Financial Group, this is what it’s like to have a review. These are the conversations we’re having with you every six months or every quarter or once a year, depending on what your review schedule is like.
It’s the ongoing conversation. It’s the ongoing analysis that really provides value and peace of mind in retirement because you’re always connected to your portfolio and your income needs and where you’re at, and of course, the goal is to catch if we’re on track or off track and then make adjustments to help get us back to where we need to be and help you sleep better at night. Hypothetical couple is Tim and Jane.
Now, we’re going to assume initially that social security is taken at both of their full retirement ages so they’re not going to take it at 62 when they retire but we will look at that analysis a little bit later on in this video. First thing, we want to go through is risk willingness for each spouse so I’ve preset these but we can slide this risk willingness up and this is the most important number down here. We’re going to start out with a conservative risk tolerance or a willingness to take risk because this is fairly common as we get closer to retirement.
We don’t necessarily want to be aggressive or at least most people don’t want to be very aggressive heading into retirement or the first few years. It may be different and that’s okay. That’s why we go through this process. The first question is if the portfolio $1.1 million in total, we’re to lose $163,000, are you comfortable? Is that too much money 12 months from now if you receive your statement and the markets are down, we’re in a recession, whatever it may be, and you are down $163,000?
In this case, Tim says, “That’s about as much as I’m willing to lose. I want to retire in three years. I don’t want to take excessive risk and I definitely don’t want to work past 62 because I don’t like my job and I’m just ready to retire.” We go from there, we want to have the same conversation with Jane. Jane says, “I’m actually a bit more conservative $113,000 although that would make me sick to my stomach. I understand we do need to have some type of risk in order to achieve some type of expected return,” so a little bit less risk here for Jane.
It’s important to have this conversation but she’s definitely a bit more conservative so then the conversation shifts to– Well together, how do we want to balance Tim’s risk versus Jane’s risk? What we settle on here is a little bit closer more towards Tim so we’re going to create the boundary as far as the lower end of these guardrails at about a 15% loss or $163,000. Now, it’s important to have this conversation in terms of dollars and not percentages. The reason is a lot of times we don’t equate percentages to actual dollars.
I don’t know why but it has happened throughout my career more times than I can count. If someone comes in and they say, “Troy, I’m okay losing 20%.” If they have a million dollars, I’ll then ask, “Are you okay losing $200,000?” “No, Troy, I’ll fire you immediately if my accounts went down $200,000,” but that’s a 20% loss. Always think about risk in terms of dollars, not percentages.
Now that we’ve established in dollar terms, the lower end of that guardrail or the maximum pain that we’re willing to take and still feel comfortable that we can stay invested, we have to look at the current portfolio, how it’s constructed and what are the guardrails for that particular portfolio that someone owns when they come in to see us for the very first time. This is very common with what we see. Portfolios often have far more risk than people actually understand or are able to quantify the potential downside.
In this particular example, the $1.1 million is invested about 73% in stocks or $800,000 in stocks, $300,000 in bonds. Just a simple allocation to get this point across but this type of portfolio, if we look back to the great recession which lasted from about 18 months from November of ’07 to February of ’09, this portfolio would’ve lost about 33% or $360,000. The current construction of the portfolio has guardrails that are beyond what we’re comfortable with. This is something that would have to be addressed or we have to change the risk tolerance or at least have a deeper cons a discussion about the risk tolerance. Because if the market goes down, that portfolio loses a significant value, are you going to go to cash? Are you going to sell everything and panic? That is the biggest mistake you can make. This is why this conversation is so important. Now, we want to have a quick discussion of levels of risk and expected return. From a retirement planning perspective, whenever we’re looking at how much do we think stocks will grow, or what are expected returns for bonds, we want to be pretty conservative, but you also want to understand the type of market that we’re in.
Most experts and I do this with air quotes are pretty poor at projecting future equity returns, but they are very, very accurate. Historically speaking, when it comes to projecting bond returns. Stock returns are just far more volatile. There’s far more uncertainty and there’s just less accuracy when it comes to forecasting stock returns over a 10-year period. These people have been pretty accurate when it comes to projecting bond returns though. Most experts though, we did a video on this recently, it was titled, what are the projected returns of the 60/40 portfolio over the next decade?
Something along those lines fairly recently released. Most of these let’s call pundits or economic forecasters, stocks somewhere between 5% to 7% realistically over the next decade is what they say you should expect. Bonds anywhere from let’s call it 1% to 3%. Take it for what it’s worth, but we want to be conservative when we’re projecting out potential growth for these different asset classes because if the stocks overperform and they actually average 9% or 10%, then we’re in really, really good shape.
But if they do hit that 5% average rate of return number or even less than that, we want to make sure that we have some built-in cushion or margin of error when it comes to forecasting and projecting. Now, we want to compare and contrast Tim and Jane’s hypothetical risk tolerance or how much risk they said they’re willing to take, those guardrails. Remember $113,000, I believe was the downside or $136,000 when the total score there versus how their portfolio is actually invested. We want to look at the risk levels, but also projected returns.
Then, we want to tie that into the spending level and then play around with some of those numbers and look at different scenarios. Here we have the target portfolio. This is basically how they are invested about 70% to 75% in stock. We see we have a projected return of about a little more than 6% over time with a standard deviation of 13.79%. Standard deviation is just risk. The higher that deviation, the farther your guardrails are from one another. This is based on their risk tolerance, a risk-based model. They should be in more of a balanced type portfolio.
The projected returns there would be about 4.7% with a much smaller standard deviation. The question becomes, can we still achieve our spending goals over the course of our retirement with less risk, as opposed to more risk with higher guardrails? Now, it’s important to know from a retirement planning perspective when we talk about portfolio return. The most important thing we need to focus on is portfolio risk. The return is really just what we’re trying to achieve in order to maintain our lifestyle. Completely different from the accumulation phase where we should be more aggressive.
Generally speaking, trying to achieve higher returns because we have much more time on our side. In retirement, the ball game changes differently. We need a focus on risk management and the tools that we use to manage that risk are very, very important. When we look at projected returns here, it’s much better when we’re doing this type of analysis and planning to be conservative on the projected return side. We don’t want to be aggressive in assuming the stock market’s going to make 10% or 11% a year.
Most experts do believe that over the next 10 years, stocks are going to perform much worse than they have over the previous 10 years. Now, for what it’s worth when it comes to forecasting, equity performance over long periods of time, like a decade, most of these people are not accurate. When it comes to projecting bond returns, they have proven historically speaking to be pretty accurate. I’d much rather lean in on the conservative side when it comes to planning because if we outperform and the markets do great, you’re in a better position.
But if the forecasts are accurate and the stock market does underperform relative to how it has historically, then we still plan for that. We have some built-in margin of error. The current scenario here looks at the base spending goal of $60,000 per year, the Go Go spending of an additional $25,000 when they’re young, healthy, and active during that first 10 years of retirement, but then also how the portfolio is currently invested more stock heavy. Now, again, the willingness question comes into play here in the real world because if we kept this portfolio, we stayed about 70% to 80% in stock and the market comes down 30%.
Are you going to stay invested? Are you going to ride that out because if not, it blows everything up? This is why risk management is so important. We run the trials. This is 1,000 different simulations based on those numbers. This is again taking social security, both spouses at full retirement age. We commented about 85%, but what we also want to look at here is bad timing. When we look at these two different lines here, this is looking at an average of the historical returns of that portfolio, what it could generate.
Then, we have this red line, which shows what happens in a bad timing scenario. This assumes when they retire, the markets are down 20% and 7%, or that’s the return that they achieve graphically. It is shown up here but look at the difference that timing, the only thing that’s different in these two scenarios is the sequence of returns or the bad timing risk. Those two years. Everything else is the same. Look how different the outcomes are for these two scenarios. Now, I want to dive a little bit deeper into the sequence of return versus average return.
Remember, this is for their current portfolio, how it’s invested. Now, we are then going to look at how it probably should be invested if we’re going off more of a risk-based investment portfolio. Of course, that risk is based off their saying in this hypothetical example that they don’t really want to lose more than $100,000 to $150,000 in a bad market. This is very eye-opening. What I’ve done down here is 4.7% is the average rate of return for all of these trials that we see these lines here. Actually between 4.7% and 4.8%, but look at the potential outcome difference.
This portfolio, even though it averaged, let’s call it 4.75% ends up with $2.2 million. This portfolio down here averaging the same rate of return $485,000. This red line right here, this represents a scenario where the averaged 4.75% but ran out of money. How can this happen? When we start in retirement, if we look at averaging a certain rate of return, how could we possibly have all these different scenarios? It comes down to the timing of those returns.
If you had a set of 10 and you were minus 10 in the first year, and then plus 10 in the back years compared to if you were plus 10 in the first 5, and then minus 10 in the second 5, both of those two scenarios, you’re going to have the same average return, but in the first one, because it was negative 10, negative 10, negative 10, and then the positives, that one will most likely run out of money. Even though the average returns are the same, the outcome is different. This shows us graphically, how many, this is just 16.
Literally, there are thousands of potential ways that we could average 4.7%. In the accumulation phase, when the money’s growing and you’re not taking it out, average returns are important. We typically want to lean towards having higher potential returns or higher expected returns. We can withstand that volatility. In the retirement phase, different ballgame. Once we start taking money out of the portfolio, we should really care less about average returns and focus more on managing risk to avoid big downturns in the beginning years of retirement.
Now, we’re going to look at the recommended scenario. The recommended scenario simply recommends reduction in stocks based on their risk tolerance. We’re trying to reset the guardrails. Initially, the guardrails were here, but based on their willingness to take risk, the guardrail should really be here. If they had that proper portfolio based on their risk levels, what is the expected outcome or recommended scenarios probability of success? It jumps up, not a huge jump up here, but it jumps up to 88%. We still want to explore this in a bit more depth.
First, the bad timing. We see here the bad timing, we still have a pretty decent, but it’s not as the difference is not nearly a start. Here are the years of bad returns because the portfolio was more conservative based on their risk profile. Now, instead of being negative 20 and negative 7, I believe, now the bad timing is negative 13 and negative 4. We have obviously still the decline because we’re starting to take income out of the portfolio, but we have a much more of a leveling off in these out here. Even out here, we do have a big difference here still. This is $993,000 versus $494,000 which does stress the importance of those first couple of years of retirement, but it’s not nearly as start. The difference isn’t as big. Now, we’re going to look at the average rate of return, just like we did last time for the more aggressive portfolio. This is the more conservative portfolio and we see the average rate of return. First, it’s all green. This one, $1.9, so it doesn’t quite get up to the $2.2 in the, let’s call it, best case scenario that the last scenario did, but guess what? We’ve improved the bottom, we’ve improved the lower end. There are no red lines.
None of these scenarios is projected to run out of money. At the same time, we we still have a decent size chunk of money left, even though we’re 30 years out into retirement. The big takeaways here are understand that whatever your risk tolerance is or your willingness to withstand risk, we knew we want to make sure as part of this process, that your portfolio is constructed in a way that fits within those guardrails.
It’s when your portfolio was constructed in a manner that the potential outcomes fall outside of your guardrails, that emotional stress and anxiety, which lead to bad decisions in retirement, which can blow up an entire retirement, that’s when those things happen. The very first step in the retirement success plan process is identifying where is our risk tolerance. What is our portfolio’s capacity for risk? Capacity, can it support the level of income that we need, but then also your current portfolio and the ongoing portfolio, how it’s being managed? Is it falling within those guardrails?
We can minimize the potential for emotional or anxiety to override our logical decision-making part of the brain. Now, I want to look at different spending levels so we can identify the portfolio’s capacity for risk because retirement is an unknown. We often find that people spend more in the first couple of years of retirement than they were anticipating. Those expenses, for some people, tend to taper off a a bit more quickly than they also had planned for as well. We just want to look at some of these variables. The Go Go, let’s first say, you know what? We want to spend a little bit more in retirement.
This $31,000 is in addition to the 60. We went from spending $85,000 during the first 10 years to now it’s at $91,000 during the first 10 years. That’s $6,000, that’s an extra $500 a month, $6,000 a year. Probability dropped from 88% to 81%. Is this a bad number? No, this is not a bad number. I wouldn’t say you can’t retire with an 81% probability. What I would say is this, we need to stay on top of this. We need to actually look to see what are the portfolio values, make sure you’re staying within those guardrails as far as how the portfolio’s constructed, and what are we actually spending.
If a year from now or two years from now if the trend is, this is going to 80%, 76%, 74%, we need to make some adjustments at that point, but making sure your risk willingness, the portfolio’s capacity to provide the income that you want, and also the investment structure of your portfolio. All of those things are congruent. That is the key to managing risk. Also, having a portfolio that’s designed to support you in retirement. We need to make sure those things are all connected. Just looking at one more here, let’s say, you know what? The base living expenses, the one that’s going to last 30 years throughout retirement.
“Troy, once I kind of get a little bit older, I don’t think I’m going to spend that much. I’m going to bring that down to $50,000.” Now look, we could feel pretty comfortable spending a lot more in the first 10 years of retirement on the discretionary budget during the Go Go years. As long as this was the case where we were actually going to do a lot less, and maybe this was the plan if we had certain health factors that could potentially shorten our life or we weren’t going to be as active or mobile later.
Maybe we play around with this and we bring this back to, let’s say kind of in the middle here. We’re still coming in at 90%. Having this type of analysis done initially, but then also staying connected to it. Year after year, doing this type of analysis is critical to retirement success. This is why it’s the first part of our retirement success plan. It’s managing risk, making sure that all of these things are congruent.
As the years progress, staying connected to it, really we find helps provide some peace of mind and some comfort knowing that, “Hey, I know where I’m at. I know what it means for me, not only today, but I also know what it means down the road. This is what it’s like to not only go through the first and second appointment with us at Oak Harvest Financial Group, but this is what the reviews are like. These are the types of conversations when you become a client that we have on an ongoing basis.
I hope you enjoy this video, make sure to share it with a friend or family member who you think could benefit, subscribe to the channel, of course. I’d love to see your comments down below.