How much can I spend in retirement? For many, that’s the million-dollar question – literally.
The first step taken of any retirement planning should be developing a baseline financial plan, and understanding the appropriate withdrawal rate is paramount to this process. During the early stages of plan development for our clients, we often get questions about the 4% withdrawal rule and how it applies to their situation. The popular financial “rule of thumb” was the result of research done in 1994 by a financial planner and MIT grad, Bill Bengen, and produced what is now known as the 4% Withdrawal Rule.
Trying to do right by his clients, Mr. Bengen sought out to produce something that wasn’t yet available – a framework for providing guidance that was rooted in research and data. Here’s what he came up with – a “rule of thumb” that posits that retirees who withdraw 4% of their initial portfolio at retirement, and then adjust that amount for inflation, can sustain that spending amount for 30 years and not outlive their money. The research assumed the retirees’ portfolio consisted of an equal mix of stocks and bonds (S&P 500 & Intermediate Government Bonds) and was rebalanced annually. From there, he tested every rolling 30-year period dating back to 1926 to determine the maximum withdrawal rate that would survive all periods. For that time period, the worst-case scenario in U.S. history produced a 4.15% withdrawal rate. Thus, the 4% rule was born.
Words of caution - Oversimplification
When it comes time to make the decision on retirement, and answering the ultimate question of, “Do I have enough?”, using the 4% Rule to help answer that question is a decent starting point. However, for a variety of reasons, we caution against blindly accepting this rule and applying to your situation.
Asset Allocation & Diversification
An investor’s mix of stocks & bonds (i.e. asset allocation) should be constructed in light of their financial plan and tolerance for risk (market volatility). No client situation is the same, and there are many valid reasons to have a more conservative (more bonds) or aggressive (more stocks) portfolio that deviates from the mix used in the study. For investors with more aggressive allocations, we would expect the probability distribution (Monte Carlo) of their financial plans to vary widely compared to that of a conservative portfolio. For this reason, sustainable withdrawal strategies should be informed by the actual risk and return profile of the portfolio, not the one used to create the 4% rule.
Secondly, because the dataset used is based on the historical risk and return of a portfolio split between two broad asset classes (US stocks & bonds), its assumptions are conservative compared to that of a more broadly diversified portfolio. Basic investment theory states that by adding more asset classes that move in different directions at different times (i.e. uncorrelated), you can increase your expected return (or reduce the expected risk). The reality is that well-designed portfolios should include a mix of different asset classes (i.e. small company stocks, international stocks, emerging market stocks, real estate, etc.) and by adding these different asset classes, all else equal, we can reasonably expect a higher safe withdrawal rate than the original research produced.
Flexibility in Retirement
Of all Mr. Bengen’s assumptions, the one that deviates most from reality is that retirees will maintain the same withdrawal amount every year, adjusted for inflation. In theory, people could stick to that original withdrawal rate, but the reality is we are humans, not robots, and retirement spending is never linear. Whether it's a planned car purchase or the unexpected roof replacement, portfolio withdrawals fluctuate from year to year.
The second and potentially bigger issue with this assumption is known as the "sequence of returns" risk. Simply put, this is the risk of retiring at or just before major market declines (i.e. 2008) because, like spending, market returns are not linear, and pulling from your assets early in retirement when asset prices are low can be detrimental to long-term financial health. For example, the below chart illustrates the impact that the sequence of returns has on a portfolio by charting two identical scenarios and changing only when the negative returns occur:
Source: MFS Research – Insightful Investor
The above chart is an extreme example, in practice, people tend to adjust their lifestyle during severe bear markets. Many are concerned about market returns going forward, and while we don’t know what the future holds, the bottom line is retirees are (and should be) more flexible with their spending than following the 4% rule allows.
The first priority of retirement planning is to ensure one doesn’t outlive their assets. Early retirement age combined with good health and improved medicine is the perfect recipe for outlasting your assets without proper planning. For those retirees that hang ‘em up well before 65, using the 30-year assumption could cause them to drastically undershoot their realistic life expectancies, causing major financial pain in later years. All these factors are unique to each individual’s circumstance and should be considered in developing a plan.
The Surplus “Issue”
While not running out of money is the obvious first priority for everyone, we shouldn’t lose sight of why we work hard and save money, and that’s to enjoy retirement. For many, that means optimizing resources throughout retirement to achieve their goals with little left at passing. As noted by industry expert Michael Kitces, abiding by the 4% rule overwhelmingly leaves folks with excess money at their passing:
As the chart reveals, the decision to follow a 4% initial withdrawal rate makes it exceptionally rare that the retiree finishes with less than what they started with, at the end of the 30-year time horizon; only a small number of wealth paths finish below the starting principal threshold. In fact, overall, the retiree finishes with more-than-double their starting wealth in a whopping 2/3rds of the scenarios, and is more likely to finish with quintuple their starting wealth than to finish with less than their starting principal!
While the above chart is loud and bit hard on the eyes, it demonstrates just how conservative the 4% rule is by highlighting the fact that the majority of the simulations finish with greater wealth than they started with at retirement.
Tale of the tape
So there you have it – a detailed review of the 4% rule. If you've made it this far, hopefully, you'd agree that while the work done by Mr. Bengen is solid, retirement planning is far too complex to restrict yourself to a "rule of thumb." For those looking to answer the million-dollar question and retire with confidence, don't leave it to chance. Get deliberate – build a comprehensive financial plan, align your assets with that plan and create a reporting structure that enables you to track your progress.
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