How much can you withdraw annually in retirement and stay solvent? The longtime standard answer is 4%. But 3% may be more prudent if stocks and bonds continue offering low returns into the future.
Some time ago, a major financial services company ran an ad campaign based on “the number.” This magic number is meant to assure a retirement that is “safe,” meaning not running out of money before you die. The key questions it aims to answer: 1) How much do you need to accumulate in dollars, and 2) how much can you take out each year to be relatively certain that your bank balance will not go to zero before your heart rate does?
You may have heard of the “4% Rule.” Financial planner William Bengen promulgated this in a study published in the Journal of Financial Planning in October 1994. Bengen studied 65 years of stock and bond data from 1926 to 1991, broken into 38 30-year rolling periods, seeking to determine the right withdrawal rate. In other words, the percentage of your portfolio balance that, adjusted for inflation each year, could sustain 30 years of withdrawals without depleting the asset base. Out of that study came the popular theory that a 4% withdrawal rate is reasonably safe.
Bengen feels that the 4% Rule is still valid. It is useful as a guideline, but there are caveats. Recent studies, particularly a piece by Wade Pfau, PhD, in the May 2011 issue of the Journal entitled “Safe Savings Rates: A New Approach to Retirement Planning over the Life Cycle,” suggest another look.
Part of the challenge is estimating the expected returns going forward for bonds and stocks. We are at the end of a 30-year bull market in bonds, with “safe money” yields at historical lows. On March 29, the benchmark U.S. Treasury note offered a yield of 1.85%; a five-year certificate of deposit, 1.21%. Traditionally, retirees relied heavily on bonds and CDs for peace of mind. With trailing 12 months All Items Consumer Price Index at 2% as of mid-March, safe money yields adjusted for inflation and taxation are decidedly negative.
The 4% Rule is not a “rule” – it is a theory, and even Bengen admits it did not work well during high inflation periods, which given the Federal Reserve’s current excessive money creation, may be in our future. The Standard & Poor’s 500 index on March 28 finally surpassed the previous high of October 2007. Suffering from “recency bias” (believing that the latest thing to happen determines the future), traumatized by two major market routs, many investors still are nervous about major commitments to equities. Pfau theorizes that, with lower expected returns in bonds and stocks, a reduced withdrawal rate is justified.
That’s why the 4% Rule may become the 3% Rule. This means, for every $30,000 per year that you want from your portfolio, or $2,500 per month, you have to have $1 million in capital. What does that do to your retirement assumptions?
There are no magic bullets. Longevity risk, where you outlive your money, is real. Advisors are looking at strategies to deal with the erosion of bond values amid rising interest rates (prices and rates move in opposite directions). You may have to rethink your asset mix, including how to handle volatile classes like stocks. Otherwise, as you withdraw money from your portfolio during a years-long stock retreat, you may suffer “reverse dollar-cost-averaging,” where your automatic dollar outlays buy a bunch of increasingly less valuable shares.
Many popular money management theories are based on “accumulation,” not “decumulation,” the spending down of one’s asset base.
One possible way to handle an unknowable and possibly turbulent financial future is a bucket strategy, where you divide your assets into different categories, or buckets. You withdraw income from them one at a time, at different stages of your retirement. The assets in the earliest withdrawal bucket are the least risky, the ones in the latest are the most risky.
Another technique is tactical asset allocation, where you change the mix of your assets based on the trailing 12 months’ price performance. The idea is that shift your money into the winning sectors.
Retirement security requires a multifaceted strategy that involves defining exactly what retirement is. Will you work past your full retirement age under Social Security? Have you studied strategies to maximize Social Security income? Do your have income sources beyond your portfolio or Social Security, such as a pension covering you or a spouse? Do you have obligations to aging parents or other loved ones that will drain some of your savings? Is your home paid for?
What is your health status? Will you insure long-term care risks or self-insure, meaning you save for the expense and pay for it yourself? Medicare, which is not free or simple, does not cover many health-related costs, including long-term care. Healthcare is wealthcare – medical and caregiving costs can be major factors in running out of money.
So $1 million to generate $2,500 a month? Being “a millionaire” ain’t what it used to be.
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Lewis Walker, CFP, is president of Walker Capital Management Corp. and Walker Capital Advisory Services, Inc., a Registered Investment Advisor (RIA) in Norcross, Ga. Securities and certain advisory services offered through the Strategic Financial Alliance Inc. (SFA). Lewis Walker is a registered representative of SFA, which is otherwise unaffiliated with the Walker Capital Companies. 770-441-2603. firstname.lastname@example.org.
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