by Ana Maria Martinetti-Katz, MBA, CFP®, CPA – August 2013
For a number of years now, the rule of thumb has been that a 4% withdrawal rate from a portfolio during retirement was “sustainable”. That is, it was unlikely that you would run out of money before you ran out of time. However, lately the 4% rate has been questioned and tested and some studies suggest that rate is actually less than half!
Where did the 4% rule of thumb come from anyway? In the early 1990s, a Certified Financial Planner by the name of William Bengen performed studies based on historical evidence (dating back to the mid 1920s) and concluded that a person could safely withdraw up to 4.2% (adjusted annually for inflation) of their portfolio annually over a 30-year time horizon without running out of money. Furthermore, he concluded that increasing distribution rates to 5% of the portfolio would increase one’s chances of outliving their funds by 30%. His findings spread like wildfire and have been followed by advisers and retirees alike ever since.
It is not until very recently that the viability of this historically based rate has been questioned and not surprisingly, given the market and economic occurrences of 2008. One of the variables that is causing advisors to question the 4% rule is the timing of retirement. For an individual who retires at the point in time when markets start to take a nosedive, his or her distribution rate may need to be significantly less than someone who is embarking on the same journey at the start of a bull market. This is due to the fact that not only is your portfolio losing value because of market occurrences beyond your control, but now instead of putting money into the portfolio, you are taking money out of it. This is a double whammy for your portfolio and the viability of your retirement plans. Some economists advise, therefore, that individuals who will begin regular distributions at the onset of a bear market keep those distributions at the lower end of the spectrum, around 1.8%. Adjustments to the distribution rate can be made later on down the road when markets, and investment returns, improve. Of course, another alternative may be to delay retirement until markets recover.
Another issue some advisors have with the 4% rule is that it assumes that future returns will mimic past returns. Although we know from personal experience and from reading the fine print that past results are no guarantee of future results, historical returns do give us an idea of what could happen. They also show us the variation and unpredictability of returns from one year to the other. Historical returns are “realistic” in that we are not assuming a constant growth rate throughout the life of the plan but rather accounting for ups and downs of market cycles. A simple “work around” would be to assume historical returns would be reduced across the board by a certain percent, say 2%. This would allow for historically passed returns with a conservative spin.
Furthermore in the questioning of the 4% distribution rate is the fact that people are living longer, healthier lives and as a result, have more time to be active and spend money. Consider too that the cost of healthcare is rising annually, 7.5% expected in 2013, which may put additional pressure on a retiree’s budget. This increased life expectancy and degree of health during this time means an individual will be taking money out for a longer period of time than perhaps was the case a century ago. A higher distribution rate over a longer duration means the amount taken out must be lower, all else being equal.
So what is an investor to do? Well, for starters, you need to be flexible. The first step would be to realistically consider how long you will be in retirement. Although no one can predict when they will die, if you are in good health and longevity runs in your family, chances are your retirement will last a good number of years. You also want to assess at the point in time when you are retiring whether a bull or bear market is on the horizon. Consider such variables as price to earnings ratio (among other criteria) and determine if they are above or below historical averages. Based on your conclusion of these variables, adjust your distribution rate higher or lower (higher if bull market, lower if bear market). Account for inflation, real inflation which includes food and gas and currently stands at approximately 8%, and its effect on your distributions. And lastly, don’t just set it and forget it.
Retirement planning is not stagnant, but rather fluid. It is affected by the economy, the stock market, and life events and therefore, should be revisited regularly to ensure that it is still appropriate. Be sure to check in with your financial advisor at least annually to ensure that your plan is on track and if it is not, to figure out what adjustments need to be made.