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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 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 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.
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 downsides of the strategy.
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 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 1/N Method 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 number 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, 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% for 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 for 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 2007 to October 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 then it would’ve gotten worse from there over the next several months.
In fact, by March 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 for 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 is 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 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 nothing is 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 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 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 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 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 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).