SPECIAL FROM Next Avenue
There's new thinking about the time-honored "4 percent a year rule," which doesn't hold up these days
The question of the right amount of money to withdraw from your investment portfolio each year in retirement is an often-debated topic. And lately, there’s been some new thinking on this subject.
The “4 percent rule” – originated in the early 1990s by financial adviser Bill Bengen – says that if you withdraw 4.5 percent of your retirement savings each year, adjusted for inflation, your money should last 30 years.
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But this common wisdom has been questioned in recent months, particularly with the January 2013 publication of a thought-provoking paper on the topic: The 4 Percent Rule Is Not Safe in a Low-Yield World (by Michael S. Finke, a Texas Tech University and University of Missouri finance professor; Wade Pfau of the American College; and David Blanchett or Morningstar Investment Management).
The 4 percent target is certainly a good starting point. But this simple, one-size-fits-all plan may be off the mark for many retirees these days.
Today’s investment environment, with stocks and bonds overall generating lower returns than they have historically, combined with Americans’ longer life spans, means that your retirement money needs to last longer than in years past.
When the 4 percent rule emerged, investment portfolios were earning about 8 percent annually. Today, they’re generally in the 3 to 4 percent range.
Now when you want to figure out how much to withdraw annually from your retirement funds, you need to look at three factors: your time horizon, asset allocation mix and – what’s most often overlooked – the potential ups and downs of investment returns during retirement.
Time Horizon Considering that your nest egg may have to last 30-plus years in retirement, the odds of success are highly dependent on your annual withdrawal rate.
Essentially, the younger you start tapping your retirement savings, the lower the annual withdrawal percentage must be for savings to last.
As an example, if you’ll retire at age 63, it’s probably smart to dial back your withdrawal rate to 2 or 3 percent. Retiring at age 70, by contrast, may let you pull out 6 or 7 percent of your money each year. (By law, you must start making required minimum distributions from traditional IRAs and employer-sponsored retirement plans at age 70½.)
Asset Allocation How much of your portfolio is in stocks and how much is in bonds – your asset allocation mix – will also affect the amount you can safely withdraw each year in retirement.
Naturally, most people are inclined to reduce their risk level the closer they are to the time when they need to tap their investments. While I agree with this inclination in general, putting 100 percent of your money in bonds is not likely to generate the returns you’ll need to make your money last 30 years or longer.
There is only a 35 percent chance of a retiree’s nest egg lasting 30 years with a 4 percent withdrawal rate from a 100 percent bond portfolio. But there’s a 100 percent chance of the money lasting that long with a portfolio that’s composed of 75 percent U.S. equities and 25 percent bonds (using conservative assumptions).
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If you bump the withdrawal rate up only slightly — to 6 percent — these percentages drop precipitously to 11 percent (for the all-bond portfolio) and 60 percent (for the stocks and bonds portfolio), according to an article in the September 2012 issue of Journal of Financial Planning.
Consequently, a smart asset allocation strategy in retirement is a mix of stocks and bonds. The higher the percentage of bonds, the lower your annual withdrawal rate should be.
Ups and Downs of Investment Returns Finally, you need to consider the timing of investment returns in retirement.
How much your investments earn in any given year — particularly in the early years of retirement — has a ripple effect that can impact your withdrawal rate for years to come.
Your returns in the first two years of retirement are vitally important. Just ask anyone who retired in late 2007 and suffered big portfolio losses over the next couple of years. When your retirement savings take a huge hit early on, it’s very hard to make up for that shrinkage in the future.
Here’s how investment return timing plays into the withdrawal equation. Let’s say you have $300,000 in retirement savings and plan to withdraw 4 percent ($12,000) annually for 30 years. If your portfolio declines by 10 percent in the first year of your retirement, it’s already sunk to $258,000 at the end of year one, including your first year of withdrawals.
As a result, in year two and beyond, you’ll likely need to take out less than 4 percent if you don’t want to run out of cash.
This is why it may make sense, shortly before you retire, to put a portion of your savings in a fixed annuity that will provide a guaranteed income stream for a set period of time, usually until death. Doing so will help guard against potential market downturns. The minimal amount needed to purchase a fixed annuity is typically around $10,000 to $15,000.
Over 30 years, the ups and downs of the markets can have a pronounced impact on your retirement savings.
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Big Differences From Two Portfolios Earning 6 Percent
If you earn 6 percent a year annually on a $300,000 retirement nest egg and withdraw 4 percent a year, you’d be left with $506,331 at the end of 30 years. Now, assume a 12 percent return in year one and 0 percent in year two, in a repeating pattern for 30 years. That’s still an “average” 6 percent return, but the variability would cause the portfolio to be worth just $482,535 by the end of 30 years — a difference of nearly $24,000.
The volatility of markets means you can’t just pick an annual withdrawal rate and blithely stick with it throughout retirement. Instead, you should assess the withdrawal and return rates annually to determine if the rate of withdrawal needs to be raised or lowered.
Calculating Your Personal Withdrawal Rate
Aside from these three factors, the right withdrawal rate will also depend on your total retirement savings, your tax situation and your other income sources, like Social Security, pensions and part-time work.
There are many online tools that can help you find your personal withdrawal rate, including ING U.S.'s retirement planner calculator.
You may also want to consult a financial professional who can help assess your situation and work with you to ensure that your money lasts as long as you do.