Retirement planning consists of a wild scatter plot of potential projections. Navigating successfully through possible outcomes requires regular corrections and adjustments.

Most retirement software runs hundreds of possible retirement scenarios, called a Monte Carlo analysis. Success is defined as achieving 80% or more of investment outcomes where blindly following your planned strategy means staying solvent until you die. Keeping an 80% success rate ensures that your average is much higher than depleting your portfolio. You are prepared to deplete the portfolio, but over half the time you will leave a significant legacy.

Although these projections are useful, they are seriously limited.

One software vendor includes wild stock returns, often called black swan events, that might swamp your portfolio. So the allocation recommendation given the best chance of success for long periods of time is an all-bond portfolio, exactly the opposite of what you would expect.

I pressed the software makers to explain why their program gave such a strange result. They had tried to simulate black swan events in the stock markets. But they admitted they hadn’t included any unforeseen bond or inflation events.

They did not consider a possible excessive bond default. And they simply assumed constant straight-line inflation at whatever input was provided. Muni bonds may default en masse. In fact, the United States may go the way of Greece. Alternatively, hyperinflation may return. In any of these scenarios, the all-bond portfolio doesn’t seem so attractive for long-term investing.

At age 65, retirement projections are like Lewis and Clark leaving St. Louis heading for the Pacific. They start out due west but know they will need to alter their route as they navigate the terrain. And they can also rely on their Native American interpreter and guide.

Straight-line projections don’t work within Monte Carlo. And you can’t anticipate every unexpected event. The best approach is to diversify your portfolio to reduce the risks associated with one type of investment and to make continual course corrections.

We recommend a safe withdrawal rate based on age. At age 65 that rate is 4.36%, assuming portfolios with sufficient appreciation and projections adjusted regularly.

Assume you have a million-dollar portfolio as you retire at age 65. Your safe withdrawal rate is 4.36%, or $43,600 for the first year. Inflation averages about 4.5%. A balanced portfolio might earn 5% over inflation, or 9.5% total. So in an average year you would spend $43,600. The remainder of your portfolio would gain $90,858 for an end value of $1,047,258.

Our safe spending rate at age 66 increases from 4.36% to 4.43%. If you’d only earned 3% over inflation, you would receive an approximately 4.5% cost-of-living increase at $45,562 per year. Because you earned 5% over inflation, your safe spending rate increases to $46,394 annually. The extra $832 a year is available because 80% of the time the average return for your portfolio is above our planning.

The market typically appreciates more than planned and you get an increase greater than inflation. But some years the market drops significantly. You then have to hold your spending constant, waiting for your portfolio to catch back up with average market returns.

Our minimal expectation is 3% over inflation. That is the average return of a bond portfolio. When inflation is running at 4.5%, a bond portfolio offers about a 7.5% return. Investing everything in bonds, however, is a poor idea. It gives your portfolio no average excess return to come back from bad bond markets or hyperinflation. With all bonds, your failure rate is 50% or more, too high for a safe retirement plan.

Adding stocks to your portfolio will boost your average return. If bonds earn on average 3% over inflation, stocks earn 6.5% over inflation (11% if inflation is 4.5%). Adding stocks provides an engine of appreciation over 30 years of retirement.

A million-dollar portfolio at age 65 with average returns from a 30-70 tilt toward bonds will produce $4.0 million in spending through age 100. But tilting 70-30 toward stocks will produce $6.1 million. The decision to tilt toward stocks produces over $2 million more lifestyle spending over 35 years.

Investing in fixed income gives you peace of mind. You know your lifestyle for the next few years will be relatively stable and not depend on the whims of an inherently volatile market. Investing in stocks is appropriate when your time horizon is at least five years or longer. Being overly fearful of the markets may jeopardize your retirement lifestyle.

To balance your asset allocation, we recommend keeping the next six years of spending in fixed-income investments and the remainder in stocks. You can keep five years of spending in fixed income if you are aggressive and seven years if you are conservative.

Now your retirement spending is relatively secure for the next six years. We suggest putting the remainder of your portfolio into more volatile stock investments to achieve a better long-term rate of return. Not only do you have a maximum safe withdrawal, you also have a suggested allocation to fixed income to balance the need for six years of stable spending with the need for appreciation to cover the seventh year and beyond.

Thus at age 65, 25% of your portfolio should be in fixed income. This gives you six years of safe spending. Your fixed income allocation could range from a more aggressive 20% to a more conservative 30%. Outside of this range gives you a smaller chance of maximizing your lifetime retirement spending.

Outside of this range you must reduce your withdrawal rate. If you reduce your spending, you can afford to allocate more to fixed income because you don’t need the growth. You can also allocate more to appreciation because the investments are really being managed for the next generation. If the markets drop significantly, you won’t need the money to meet your lifestyle needs.

Small adjustments in asset allocation and withdrawals provide the constant course corrections necessary to reach your goals. And these regular adjustments give your retirement plan the greatest chance of maximizing total retirement lifestyle spending and the smallest chance of depleting your assets prematurely.

Photo by Megan Marotta