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The year is 2004. You have done a creditable job of building your financial planning practice over the last ten years. Your retirement clients are particularly well-satisfied. You have demonstrated to them the virtue of a diversified portfolio of investments to provide income during retirement. The markets have been kind, if not overly generous; your client's portfolios have enjoyed return well in excess of bank savings accounts and certificates of deposit. They perceive you as having enriched their live, and they are grateful....
It is 2006. The markets have turned sour as a weak Federal Reserve Board has allowed inflation to spiral out of control. The stock market has plummeted 35 percent during the last 2 years, the worst losses since the 1973-1974 recession. Many of your clients are alarmed, worried that they will have to cut back on their lifestyles to preserve capital in their retirement accounts. You soothe them, reminding them that you carefully computed their rates of withdrawal based on average rates of returns experienced by the markets over the years, and that the markets will recover. However, you cannot help feeling a gnawing concern that you have overlooked something....
It is 2009. True to your forecast, the stock market has recovered nicely during the last three years, and most clients' portfolios have regained almost all their lost nominal value. However, your clients have a new complaint: they cannot live on the withdrawals they have been making. Inflation, averaging eight percent over the last five years, has so eroded their purchasing power that they must substantially increase their withdrawals--or face a drastically reduced quality of life. When you compute the effect on your clients' portfolios of these much higher levels of withdrawals, you are shocked: many clients will delete their assets in less than ten years, even though in many cases their life expectancies are much longer. You have very bad news to tell them. What could have gone wrong?
The above scenario is fiction, of course, but it could easily have been played out several times during this century. The logical fallacy that got our hypothetical planner into trouble was assuming that average returns and average inflation rates are a sound basis for computing how much a client can safely withdraw...