The charts and tables below are designed to illustrate an individual's financial glide path through life. They illustrate the transition from living off of your labor (Human Capital) to living off your savings (Financial Capital). Here are the assumptions for the calculation of Human, Financial and Total Capital.
1. Human Capital is defined as the present value of an individual's future earnings. Of course, your salary, bonuses, inheritances, talents, skills, education, health and other factors throughout your life will likely vary from our assumptions.
2. Financial Capital is defined as the current value of an individual's retirement savings.
3. Total Capital is the sum of human and financial capital and, hopefully, will stay constant or even increase over your life.
We also assume that an individual begins working at age 22, retires at age 67 and lives until age 85. Full retirement age had been 65 for many years. However, beginning with people born in 1938 or later, that age gradually increases until it reaches 67 for people born after 1959.
Our hypothetical wage earner's starting salary is $45,000/year and increases with inflation at 3% annually until retirement at age 67, when it reaches about $165,000. We assume an annual savings rate of 7% of gross salary (but you should strive for 10%), which is contributed to the Financial Capital and invested in the corresponding IFA Index Portfolio shown. In the figures below, every 5 years, the risk level drops down 5 risk units on a scale of 100 IFA Index Portfolios.
IFA offers a Glide Path strategy that reduces one index portfolio per year, based on a 100 Index Portfolio scale. IFA implements the Glide Path strategy by reducing the targeted risk level by one level per year. IFA does not automatically place trades on the Glide Path anniversary. Instead, IFA will evaluate the current portfolio against the new targeted risk level, and if the current portfolio is about five or more risk levels away from the target, then IFA will proceed with a rebalance. However, if IFA is aware of an upcoming cash need for the client (i.e., investing a deposit or raising cash for a withdrawal), then IFA will postpone the rebalance trades so that both tasks may be accomplished simultaneously, which translates into lower costs for the client.
To see the impact of a Glide Path strategy on the growth of a dollar, the annualized return and the risk over a 50 year or 86 Year period, see the data in the first figure below presented in the Glide Path mode. By rolling over the annual return bars, you can see that the Index Portfolios reduce by one portfolio per year, from 100 to 51 over the 50 year period. In the second figure, you can see the impact of the Glide Path over many different periods. These are charts programmed in Flash and therefore not visible on an iPad or iPhone.
Upon retirement, the retiree withdraws 5.75% of the accumulated Financial Capital to fund their annual expenses. This amount increases annually with inflation. Please note that the 5.75% withdrawal rate is applicable only for portfolios that are heavily loaded with the risk factors of small cap and value. It is IFA's opinion that these portfolios are best held with the assistance of a qualified investment advisor. The frequently cited safe withdrawal rate of 4% is based on a relatively simple index portfolio that is not tilted towards compensated risk factors other than the market. The 4% rule also assumes perfect investor behavior, which we know is not the norm. A high degree of emotional discipline is needed to adhere to a factor-tilted passive investing strategy over the entire glide path. The 5.75% withdrawal starts at about $154,000 in the golden years of retirement and replaces 93% of the annual paycheck at age 67. This does not include Social Security benefits expected to be received in retirement. To verify these results, we also ran a Monte Carlo simulation in the IFA Retirement Plan Analyzer which performed 10,000 trials under the same deposit and withdrawal assumptions, and found that in 86% of the trials, the portfolio survived to age 85.
The rate of return assumed on Financial Capital is determined by using the 86-year historical annualized returns of the changing IFA index portfolios indicated along the glide path, which is a conservative annualized return because the period begins in 1928 and includes the Great Depression (see www.ifabt.com). If you think there will not be another Great Depression, then your Financial Capital may be higher than shown. Again, please don't try this at home alone. According to Morningstar, even do-it-yourself indexers, who understand many advantages of index funds, have been shown to only capture 82% of the index fund's returns, due to bad investor behavior. Worse yet, other active equity fund investors have demonstrated that they capture about 50% of what an advised index investor earns.
We assume that at a given age, the investor is invested in the IFA Index Portfolio that corresponds to 115 minus the investor's age and changes down one index portfolio each year during their life. This 115 minus your age rule is a very rough approximation of the risk capacity and risk exposure levels for investors. Very high risk capacity investors could add approximately 20 and low risk capacity investors could subtract 20 or more from the index portfolio number. To determine your risk capacity and a corresponding risk exposure in the form of an IFA Index Portfolio between 1 and 100, please take the Risk Capacity Survey. To personalize a retirement plan for your situation, please see IFA's Retirement Plan Analyzer.
IFA has implemented its glide path portfolios as the basis for a set of Target Date Index Portfolios for clients and 401(k) participants. For example, in 2015, an individual with a target retirement date of 2030, would be about 50 years old and the glide path would put that individual's portfolio at IFA's Index Portfolio 65 in 2015, followed by Index Portfolio 64 in 2016, and Index Portfolio 63 in 2017, etc. The chart below illustrates how the glide path is structured (to view fact sheets for the IFA Target Date Index Portfolios, please click here):
The chart below shows how the returns and risks compare between the IFA Target Date Index Portfolios, the S&P Target Retirement Indexes and Vanguard's Target Retirement Funds. IFA clients and participants in IFA advised 401(k) plans can implement this strategy with the help of an IFA Wealth Advisor. Please call us to discuss how: 888-643-3133.
About the Author
Mark Hebner - Founder, Index Fund Advisors, Inc.
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.