Sixty years-old, single, with no children, and newly retired, Henry Potter has $1 million in regular assets and expects to collect $20,000 from Social Security starting at 62. He’s done well investing in large cap stocks. Since 1926 the S&P 500 has averaged 9.16 percent per year after inflation. If Henry could count on this return, he could spend $69,812 in today’s dollars for the rest of his life.
ESPlanner’s Monte Carlo analysis assumes that Henry will spend each year based on the real returns he expects to receive. Thus, if Henry chooses to hold only stock this year, ESPlanner assumes he’ll spend $69,812 this year. In assuming such aggressive spending behavior— spending based on the returns one expects, not their risk—ESPlanner demonstrates the downside risk of investing aggressively without spending defensively.
Henry sees this problem clearly in the top living standard risk-reward chart. It shows the 5th, 25th, 50th, 75th, and 95th percentile curves of Henry’s living standard as he ages. Note that all the curves except the top one head south; clearly, in holding only stock and spending in the assumed risk-neutral manner, Henry faces an every greater chance of experiencing a significant living standard decline.
After contemplating this chart, Henry considers investing everything in Treasury inflation-protected bonds (TIPS)—yielding 2 percent after inflation. Doing so would let Henry spend $38,660 for sure in all future years. This spending is shown by the dark horizontal line. This investment strategy protects Henry’s living standard, albeit at the price of limiting his upside. On the other hand, he’s protected from major downside risk; Investing just in the S&P means, for example, that at age 70 (in 2017), Henry has a 25 percent chance of experiencing a living standard below the TIPs level. By age 90, this probability is 50 percent.
As a third option, Henry considers a 50/50 mix of TIPS and large caps. With this allocation, Henry limits his downside risk (see the bottom chart), but also his upside. So, what should Henry do? The answer depends on Henry’s attitude towards risk. If he wants to play it safe, he’ll go for the TIPs and sleep soundly at night. Alternatively, as we’ll show in future versions of ESPlanner, Henry can keep the downside curves from heading south by spending at a much lower level when investing in stock.