Retirement Progress: How to Choose the Right Benchmark

Written by: Oscar Vives

Retirees (or those nearing retirement) must wrestle with many questions as they near retirement. Questions like, do I have enough to retire? How will I invest during retirement? How will my portfolio produce the paychecks that I will no longer receive? What happens if there is a stock market crash? How will I manage taxes in retirement?

A critically important question that is not often asked is, “How will I benchmark my progress during retirement?” How will I know whether I am on track or off track? As a retiree, it’s easy to get caught up in how the stock market is performing—particularly when 1) headlines constantly refer to the S&P 500 as a measure of stock market performance, and 2) it appears that everyone is measuring their progress against the S&P 500. This article seeks to provide a benchmark that could be more meaningful to you as well as illustrations to help you visualize the concept.

The Problem with Benchmarking Against the S&P 500

The S&P 500 measures the performance of the top 500 publicly traded companies in the U.S., and it’s often viewed as the pulse of the U.S. stock market. For younger investors in accumulation mode, benchmarking against the S&P 500 might make sense, particularly if they have an all-stock S&P 500 portfolio. However, for retirees, this benchmark can be misleading.

Here’s why:

1. Market performance isn’t tied to your goals: The S&P 500 might deliver 10% in a year, but if your retirement plan only requires a 4% return to meet your goals, that extra 6% doesn’t change much in your day-to-day life. Similarly, if it’s down 10%, it might cause unnecessary stress, even if you’re still on track. Such movements in the S&P 500 benchmark won’t reflect the actual hit to your lifestyle or whether you’re still on track for your retirement goals.
2. Your portfolio will likely be invested differently than the S&P 500: While you may own an S&P 500 fund in your portfolio during retirement (or many of the stocks that make up the index), it is unlikely that you will own a 100% stock portfolio during retirement. You will likely also own various other investments (such as bonds, CDs, international stocks, small company stocks, etc.). The performance of these other investments will be different from the performance of the S&P 500, and that is both normal and okay. There are years when these investments will “underperform” the S&P 500 and when they will “outperform” the S&P 500.
3. It doesn’t consider withdrawals: Retirees regularly draw from their portfolios to cover living expenses, which is the opposite of younger investors who add to their portfolios. The S&P 500 doesn’t account for these withdrawals, nor does it track the sustainability of your retirement spending. As I often tell clients, the S&P 500 doesn’t have goals or fears, does not retire, does not have to manage risk, and doesn’t have a life expectancy. Therefore, you compare apples to oranges if you attach your progress to an index with a different investment profile.

Benchmarking Retirement Progress Using a Critical Path®: A More Meaningful Approach Than the S&P 500

The Critical Path® is designed to measure your progress based on the specific asset level you need to maintain your lifestyle and meet your financial goals throughout retirement. It is a customized glide path, illustrating the minimum amount of assets you need to have remaining at the end of any year for your retirement plan to work throughout its projected lifetime. It provides a personalized financial roadmap, showing where you should be at any point in time.

To determine your customized glide path, you need the following key ingredients:

1. You need to determine your planning horizon. This is easier said than done. Someone once said, tell me when you will die, and I will create the perfect retirement income plan. As we all know, we don’t know when our time will come, but we need an estimate for our exercise.

You need to know how much money you will be withdrawing from your portfolio over your planning horizon. This requires you to project your income and expenses over your planning horizon. What are your fixed income sources (i.e. social security, pension, etc.)? What are your total expenses? The difference between the two is the amount that must come from your investments. What makes this a challenging exercise is accounting for federal and state income taxes as well as one-time items that seem to happen every year.

You need to know the value of your current retirement assets. This is the easiest of the key ingredients.

To illustrate this concept, let’s imagine that we have a 65-year-old woman (Jane) who has determined that she needs to distribute $100,000 annually from her investment portfolio to meet her spending goals (over and above social security and any pensions). Jane would like to increase this distribution by 3% annually, and she has determined to use a 25-year planning horizon (so that the financial plan will take her to age 90). In this simplistic scenario, Jane needs $100,000 in year 1, $103,000 in year 2, etc. (until she needs $203,279 in year 25). Assuming a 0% return, Jane would need a total investment portfolio of $3,645,926 to meet this distribution pattern. The ending balance column shows how much money Jane must have in her account at the end of each year to meet the desired withdrawals over the remaining period.

This is an extreme example, as it is rare for a person (or couple) to have sufficient investment assets to fully fund their retirement expenses without needing to earn a rate of return. Let’s instead assume that Jane has $2,500,000 of investment assets. In this case, Jane needs to earn an annual rate of return of 3% to meet her spending goals.

Below is a picture of what Jane’s Critical Path® would look like in this scenario.

An important point to remember is that while the Critical Path® line illustrates her portfolio going to 0 at the end of the 25 years, this is not the likely path of her portfolio. It is simply the minimum path that her portfolio needs to take to meet her spending goals. Anytime Jane’s portfolio value is higher than the Critical Path®, Jane would be in the safety zone (she can continue as usual, she may decide to spend more money, etc.). If her portfolio value dropped below the Critical Path®, Jane would be in the danger zone and would have to consider making adjustments to her spending (such as foregoing the annual inflation adjustments for some time or even cutting spending).

Why the Critical Path® Is a Better Benchmark

Let’s look at some key reasons why benchmarking against a customized path is a more thoughtful way to gauge your financial health in retirement:

1. It’s goal-oriented based on your specific situation: Unlike the S&P 500, your Critical Path® is based on the income you need, your planned spending, your expected longevity, and the returns your assets need to generate. This is a custom benchmark tailored to your personal goals, not a generic index. It also reflects the sustainability of your withdrawal strategy, so you can see if your spending habits are in line with your plan.
2. You can back-test historical retirement scenarios to see how you would have fared relative to your specific spending plan (instead of trying to fit yourself into a rule of thumb). If you take your Critical Path® and overlay historical retirement periods (that match your planning horizon) to a given asset allocation, you can see how your specific plan would have fared in various historical settings. In our firm, we call this a historical audit.
3. It reduces stress: A Critical Path® gives you a clearer picture of your financial health. Instead of focusing on market highs and lows, you can concentrate on whether you’re meeting your personal milestones. It helps you avoid unnecessary stress from short-term market volatility, allowing you to focus on long-term sustainability.

To illustrate this further, let’s assume that Jane’s returns over the first 5 years of her retirement are 11.76%, 14.05%, -13.10%, 14.24%, and 9.54%. Below is an illustration of her portfolio relative to her Critical Path®. The yellow line represents Jane’s hypothetical portfolio values over the first 5 years.

As you can see, the good returns on Jane’s portfolio over the first two years provided an initial cushion. In year 3, when Jane’s portfolio decreased by 13.10%, she was still ahead of her path. As a result, no adjustments are warranted. If you view the negative returns in isolation, you might feel the need to make changes unnecessarily. Market fluctuations are inevitable, but your Critical Path® provides a reliable guide to follow. By sticking to it, you can avoid the emotional decisions that often come from watching the market too closely.

There are further benefits to using a Critical Path® monitoring system that are outside the scope of this article, such as determining an appropriate asset allocation given your required rate of return, aligning your investments to your spending plan, determining a suitable time to rebalance your portfolio, navigating market swings and changes to your financial plan.

Related: After the Death of a Loved One