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Implications of small changes
Old 04-25-2011, 12:33 PM   #1
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Implications of small changes

Was playing around in Excel today and itís very disturbing to see how very small changes in parameters lead to extremely different results. I have been toying with the idea of leaving full time work at 40 and then working on a temp/consulting basis for the next ten years. Assume the following.

Paid off home

Nest-egg at 40: $800,000

Part time employment: $25,000 after tax in first year inflated at 2% until age 50. No income until 65 when Canadian pension kicks in

Pension: Assume $18,000 per year received at age 65 inflated at 1.8% per year for Canada pension (this is in future dollars Ė about $11k in todayís money)

Spend: $40,000 per year inflated at 2.5% per year (after tax)

Return: Assume a constant 5.5% return each year from a 60/40 portfolio

Result: At age 95 left with $773,000

Now, change the return from 5.5% to 5% and we get a deficit of $845,000 a $1.6Million difference for just a .5% change to our return

OK, now go back and assume the 5.5% return on investments again, but assume inflation increases 3.5% each year (rather than 2.5%) on our expenses starting with that $40K expended in year one. Result is now a $4.2Million deficit at age 95!!!!!

Am I doing something wrong in my calculations? This is very eye opening for me. Presumably if expenses were going up at a rate of 3.5% one would do some serious cutting to get the withdrawal rate back in line but I think it shows how fast things can go off the rails.

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Old 04-25-2011, 12:35 PM   #2
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Old 04-25-2011, 12:43 PM   #3
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I have the same problem with my Excel sheet, Accountingsucks. The best we can do is plan for the worst (i.e. higher inflation, etc.) and hope for the best... Easier said than done.
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Old 04-25-2011, 12:50 PM   #4
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Actually, it is not Excel. That is just the nature of reality.

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Old 04-25-2011, 01:23 PM   #5
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Get a new spreadsheet.

Spreadsheet portfolio simulations use averages - average return on investment, average inflation, etc, while in real life those variables will deviate substantially from the averages, especially the constant rate of return. It seems from your scenarios that your withdrawal rate is greater than your real rate of return, so yes, 0.5% less return (or 0.5% more inflation, which is effectively the same) will draw down the funds that much sooner. Once you reach zero, a bigger or smaller deficit doesn't help much - you're still out of money.

Firecalc helps you look at portfolio survival probabilities, which may be more meaningful, especially when projecting over long periods. Have you used it?
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Old 04-25-2011, 02:19 PM   #6
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If 5.5 % gives better outcomes...

Just think what you'll get when use use 10 % !
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Old 04-25-2011, 04:27 PM   #7
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Most likely yes. Compounding makes a big difference but not like that. Try FireCalc as the results are much better predictors than a spreassheet average. Also make sure you check your formulas in Excel.
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Old 04-25-2011, 05:06 PM   #8
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It's just money It sucks at times huh? One thing I struggle with is early retirement can last a very long time, many moving parts that can change with very little control on your part.
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Old 04-25-2011, 05:13 PM   #9
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This is not surprising - given enough time even small changes to either the rate or return or the rate of increase in expenses (or inflation if you prefer) can compound to become significant.

Try playing around with the inflation number in FIRECalc - even relatively small increases in the inflation rate will significantly lower the expected success rate. Quite frankly, it is only belief that there is a realistic possibility that inflation will exceed the FIRECalc assumption that is currently keeping me in the w*rk force.
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Old 04-25-2011, 08:57 PM   #10
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And Excel was supposed to make our life easier!

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