So as longtime viewers of this channel will know I believe that from a purely financial
perspective there are four factors of a successful retirement withdrawal strategy. The four factors,
in no particular order, are income, risk, stability, and buying power.
Income is defined both by how much money is coming in the door each month or year as well
as when that money is coming in. This is because not all retirement withdrawal strategies are
systematic and linear with their income growth (or decline in some instances). And since
none of us know precisely how long our retirement will be going in we tend to put more of a
priority in having abnormally high-income years in the earliest portion of our retirements
than in the later part of our retirement that we may or may not even get to.
Risk is essentially just the likelihood of outliving your money.
Stability is graded by how often you experience anything that would be considered an undesirable
change in your income from year to year. This could come in the form of a freeze on the
growth of your income or a decline in your income.
Buying power is defined just like it always is, by measuring what your money can actually
get for you at any given time and is largely tied to inflation.
We all have different priorities in retirement. Some want their risk of outliving their money
to be as low as humanly possible and are willing to take a lower income with less stability
in order to achieve that. Others want to maximize their incomes over whatever time they have
left and are willing to take on the additional risk that generally comes with that. Still,
others are comfortable with the lifestyle that their current projected retirement incomes
provide and just want to avoid seeing that income change for the worse. You get the picture.
We’re all looking for slightly different things and that’s why there are so many
different methods of withdrawing money in retirement. They all correlate to high levels
of success in one or a few of these areas.
For those who are looking to maximize their incomes, today’s method may be the one for
you because today we’re going to be talking about the 1/N Method. We’re going to be
covering how to use it, the pros and cons associated with it as well as how to mitigate
some of the downsides of the strategy. Let’s get started.
So as I said the 1/N Method is a retirement withdrawal strategy that seeks to maximize
your income in retirement over a predetermined length of time.
This, and other income-focused methods like it, is an intriguing method for some because
most other popular retirement withdrawal strategies such as the 4% rule share a common complaint…
they all assume that the worst-case scenario is going to happen to us in our retirement.
They set their income limits based on how much we could reasonably draw from our portfolios
even if we experienced a major market downturn thus setting us up in a way that we never
run out of money, and while that isn’t the case 100% of the time it is the case in the
vast majority of scenarios, but that conservatism also means that in the vast majority of scenarios
you will not actually use a good chunk of your money.
Which admittedly for some, including myself on a personal level isn’t even an issue,
as I’d rather have a healthy amount left over, both for my own sanity and stress levels
while I’m alive as well as for an inheritance to my family or a gift to someone, or something,
else, when I’m dead, it turns out that for some it is considered an issue. The 1/N method
attempts to fix that.
Here’s how it works: The 1/N Method is an equation that tells you what portion of your
nest egg you can withdraw each year in retirement. The N in the equation is simply the amount
of years that you still expect to need to withdraw your money. This number is adjusted
each year as you age. So if you retired at 70 and thought you would need to continue
withdrawing money from your nest egg until you were 80 you would have 10 years of withdrawals
to make. Therefore N would equal 10 in your first year of retirement, 9 in your second
year, 8 in your third and so on until you turned 80 when N would be equal to 1 and you
would withdraw the rest of your savings to live on. This is how the method maximizes
income, and the difference between it and a more conservative rule of thumb like the
4% rule can be astounding.
If we assume that John is 70 years old and expects to need his money to last him until
he is 80 and, just like in last week’s video, we assume that John’s retirement savings
is $1,000,000 that would mean that he would withdraw 1/10th or 10% of that nest egg or
$100,000 to live on in his first year of retirement, leaving him with $900,000 in his investments.
Let’s assume that John’s investments grew by 8% during his first year of retirement
that would mean that come year 2, assuming his expectations of how long he would need
his money to last him had not changed, he would have a net worth of $972,000 and would
withdraw 1/9th or about 11% of that amount or $108,000 to live on for the year, leaving
him with $864,000 invested.
One nice thing about the mathematics behind the 1/N Method is that, because the portion
of your investments that are being withdrawn each year is going up, your withdrawals will
go up year after year as long as the market doesn’t experience a crash. Even if the
market doesn’t grow as fast as it did in the past, you can still maintain most of your
standard of living.
Just as an example, say that the market stayed flat during John’s retirement, he would’ve
withdrawn $100,000 in his first year of retirement just like before leaving him with $900,000.
In year 2, since his investments stayed flat, he’d withdraw 1/9th of his $900,000 portfolio,
or again, $100,000, leaving him with $800,000. In year 3, he’d withdraw 1/8th of his investments,
which is still $100,000. Inflation would erode the buying power of this over time, but you’d
still be able to maintain most of your initial lifestyle again unless the market crashes
that year.
But of course the market does crash once in a while and that’s where we do find the
first potential con of the 1/N Method. It’s stability, particularly in less than ideal
times is questionable at best and can be terrifying at worst.
Say if the market dropped by 20% over the course of John’s first year of retirement.
He withdrew $100,000 in his first year leaving him with $900,000 invested to take the hit
of the market crash. After the crash, his portfolio would be worth $720,000 to start
year 2 of John’s retirement. He’d withdraw 1/9th of that or about $80,000 to live on
leaving him with a mere $640,000 in his nest egg. That’s a solid 20% reduction in his
income before even taking things like inflation into account and a drop of 36% in the value
of his savings over the course of 2 years!
Like I said it’s questionable at best, but what if we had another drop as we did during
the Dot Com bubble or the Housing Crisis? From October of 2007 to October of 2008, the
market fell by over 42% with the S&P 500 falling from over $1,560 a share to just under $900
a share. If John had been unlucky enough to retire at that point he could’ve seen his
net worth drop from $900,000 after making his first withdrawal to about $518,000 by
the end of his first year and (after making what in that case would be about a $57,500
withdrawal for his second year of retirement expenses) down to about $460,000! And since
the market wasn’t quite done falling at that point in time it would’ve gotten worse
from there over the next several months. In fact, by March of 2009 (when the market finally
bottomed out at around $683 a share) John’s net worth would’ve been a paltry $350,000.
That’s quite a big drop over the course of a year and a half, but again that is only
happening during one of the worst possible scenarios we’ve seen in the entire history
of the stock market, so while it is technically possible I wouldn’t consider this extreme
of a scenario being likely.
The other potential con to using this method of retirement that I’m sure all of you have
already thought of is that if you live longer than you were expecting you run the risk of
outliving your money.
This can be managed to a certain degree by thinking of the amount indicated by the 1/N
method as the absolute maximum you can afford to withdraw each year, and not necessarily
always the amount you actually do withdraw.
For example, John could say that $100,000, or 1/10th of his investments, is the most
that he can take out in his first year of retirement, but there’s nothing saying that
he can’t choose to take out $75,000 that year and leave the rest in to grow. This would
help to give him more of a cushion down the road should he need the money for longer than
he was initially expecting.
Also, if he did this, and was particularly flexible with his spending during major market
downturns, it would help mitigate some of the damage that we just saw.
For example, if he did only take out $75,000 to live on in his first year of retirement
and that first year of retirement started in October of 2007, right before the start
of the Housing Crisis, he would’ve had $925,000 leftover in his nest egg. The crash would’ve
brought that amount down to about $533,000 by October of 2008 when it came time for John
to withdraw his second year’s worth of living expenses. But since he saw how big the crash
was, and by then couldn’t be sure that the worst was over with, he could’ve been extra
conservative with his withdrawals for that year in order to conserve as much of his savings
as possible. Say if he dropped his withdrawal down to $40,000 just for the one year to conserve
his savings, that would mean he would have about $493,000 leftover. That would fall to
as low as $375,000 by March of 2009 before starting to bounce back as the market recovered.
Now a difference of $25,000 may not seem like a lot to some, but in retirement, it can make
a big difference.
In summation, based on the four factors of retirement, the 1/N Method scores incredibly
highly on income, but fairly low on risk, it’s stability and to a lesser extent buying
power is largely dependent on investment performance and therefore varies from person to person
(for example your stability could be reasonably high if you had all your money invested in
money market funds, but then you’d lose some buying power to inflation. However, if
it’s invested in stocks your stability may be lower due to the volatility of the investment,
but over the long haul your buying power is likely to be okay most years). On the whole,
most of us that retire will have our money split between several investments like stocks,
bonds, possibly real estate, and more secure savings like money market funds, CDs, or banks.
Therefore the stability is likely to be roughly average for most of us (and by average I mean
good most years, but not so good here and there due to occasional market crashes) and
the buying power will likely be solid (since most well-diversified portfolios at the very
least keep pace with inflation).
So what do you think of the 1/N scenario? Let me know in the comments section below.