Time to Retire, is it still safe to withdraw 4%?
How much can retirees withdraw from their nest egg each year? This is a question that many thought was answered by the 4% rule, first articulated by Bill Bengan in 1994. Bengan is a retired financial planner from Southern California, and he published a book for financial planners based on his historical research, one that he called the Safemax or the maximum safe historical withdrawal rate. For more information on the safe withdrawal, rule see https://en.wikipedia.org/wiki/William_Bengen.
Does this rule still apply today? There is a general concern in the financial planning community that this may not be valid due to some factors that were not present in the past. Factors such as increased longevity and the current historically low-interest rate environment are troubling. Low-interest rates affect a large portion of a retiree’s portfolio which may have 40-50%, or more in cash and bonds. The high returns earned in US stocks over the last one hundred years may not be sustainable. This was a time when America became the dominant economic power in the world.
Will that continue? It is hard to say, but those issues point to potential problems.
Academic studies from Texas Tech University by Michael Finke, Ph.D., CFP® and the American College by Wade Pfau, Ph.D., CFA raise concerns about the viability of the 4% rule. They jointly published a very interesting, and somewhat technical article that sheds a great deal of light on the topic. They both continue their research for the profession.
Time will tell if retirees can maintain a 4% safe withdrawal rate. In the meantime, we believe it is time to consider some alternative strategies. Retirees should consider building a retirement projection using an assumed rate of return, inflation projection, tax assumption, etc. and a detailed look at their spending patterns. This plan should be updated annually and reviewed to determine actual performance versus the assumptions.
Are they earning the amount they expected, are they spending what they thought, is inflation higher or lower? Longer term trend lines reveal whether the portfolio is at risk or if they can safely withdraw at a higher rate. Most plans will have a constant ebb and flow. Retirees want their nest egg to be last, yet they want to draw as much income as possible to enjoy their life. If you think about it, these two goals are in conflict.
We suggest retirees look at spending in three categories. They need to know their absolute minimum, required expenses. These tend to be fixed. Then look further at the expenses that are variable including, entertainment, vacations, dining out, and gifting as examples. One might build some ranges around these expenses. The idea is they must have X, they would like to do X, and it would be great if they could do X.
Once complete, they have created a framework for a withdrawal strategy. On that could utilize a hybrid of the 4% rule.
Briefly, the design of the 4% rule allowed people to withdraw 4% in the first year of retirement, then increase that withdrawal by the amount of inflation each successive year. In rising markets, the system works well. If a Bear market occurs early in retirement, problems can arise.
An example serves to illustrate, if a person had a million dollar portfolio when they retire, they suffer a 20% decline, the result would be a $200,000 loss, a $40,000 withdrawal and a portfolio balance of $760,000. Then in year two, assuming inflation was 2%, they would withdraw $40,800. This would compute to be a distribution of 5.37%. That amount would be considered too high, by most.
A remedy to that situation would be to withdraw 4% of the portfolio each year. This would mean in the example above the client’s income would decrease to $30,400. For most retirees, this represents too much volatility in their income. A hybrid strategy may be the best way to incorporate the best of each, going forward.
The idea would be to use the 4% withdrawal strategy and modify it based on how the portfolio performs. A retiree could create a range of withdrawals based upon different investment outcomes. They could create a range of 2% on the low side and a high of 6%. This way in down years there is less pressure on the portfolio, and in up years they could spend a bit more. The volatility of income could be addressed by waiting a few years to make adjustments.
If as suggested above, people were to create ranges around their variable spending they would have some guidelines to utilize for adjustments. A retiree’s vacation budget might include trips to Europe if things are going well, or visits to see family in the US in down years, as an example. The key is flexibility.
A hybrid system of the 4% rule will potentially stop bad things from happening while there is still time to adjust. Retirees need a road map where they can make good decisions about the probability of success in a long, enjoyable retirement. It is good for people to gain some clarity on how to best use their resources to help manage their greatest fear – running out of money. Keep in mind that in most environments the worst will not happen and retirees will likely be in a position to withdraw higher amounts from their nest egg, but it pays to be prepared!