Last week in Parts One and Two of this series, you read about the commonly accepted 4% withdrawal rule. This rule of thumb suggests that if you have an equally balanced portfolio of stocks and bonds, you should be able to withdraw 4% of your retirement savings each year adjusted for inflation and those savings should last 30-35 years. Today, I consider an alternative point of view, and then review modern studies and reports on how the 4% withdrawal rule is viewed in the context of market returns over the last decade.
Set Retirement Withdrawal Rates Should Never be Used!
If you agree with Moshe Milevsky’s opinion (see his quote in Part 1) that any rule that starts with a set withdrawal rate, whether 4% or 3%, is a horrible rule, then you should just read to the end of this section and click the exit button (however, please come back for Parts 5 and 6). From what I can gather, Mr. Milevsky and many other retirement experts do not like the 4% rule because it uses a constant spending amount and does not adjust to your evolving level of wealth. By shunning a set withdrawal rate, retirees may avoid spending shortfalls where their investments underperform and will not accumulate surpluses when they outperform the market. My interpretation is that Mr. Milevsky feels you should spread your economic resources over your entire life and that your spending rate and retirement withdrawal number should not be fixed to an arbitrary level, but that your spending rate should depend upon your personal preferences and your views on longevity risks.
Mr. Milevsky may be critical of a set withdrawal rate, but he does not just point out the flaws and walk away. In his book The 7 Most Important Equations for your Retirement he provides a unique set of mathematical equations to determine your retirement needs.
These equations allow you to determine amongst other retirement issues, how long your nest egg will last, what is your suitable spending amount, and in his final chapter he helps you determine if your current plan is sustainable.
I found this book innovative and as entertaining as a math book could be (Moshe uses seven historically famous people to introduce his equations). However, to be honest, I had challenges with the math, especially the final equation in Chapter 7. You may want the math wiz in the family to assist you with your calculations. I would suggest at minimum, you use Moshe’s equations to back-test whatever retirement nest egg and spending rates you arrive at.
Before I move onto the modern safe withdrawal rate studies, I have to give a shout out to Michael James, a fellow Canadian personal finance blogger who created his own strategy, which includes holding five years of savings in a savings investment account. His "Magic Number" calculator is here. The background to his calculator is discussed in his blog post titled "A Retirement Income Strategy" and in this second post on the topic.
The Bengen and Trinity studies, from which the 4% withdrawal rule originated, utilized stock market data from 1926 to 1976 and 1926 to 1995 respectively. Many commentators feel this historical data is no longer applicable in today’s world.
To help you determine if 4% is a safe withdrawal rate for you (with the limitations I noted in my first post), I’ve summarized below several current studies and reports on this topic. Some of the studies/reports continue to condone the 4% withdrawal rate or are at least accepting of using a 4% withdrawal rate as a starting point. Others feel it is excessive and if you withdraw 4%, you will be eating cat food at some point in your retirement.
If you are like me, you will probably be overwhelmed by these reports, their arguments and their data. Although you will never achieve certainty, your withdrawal percentage is the vital wildcard in trying to estimate your retirement nest egg and, you must draw a line in the sand using a percentage within your comfort zone, assuming you believe in a constant withdrawal rate strategy or a variation of the strategy.
In this report by Rob Williams, Director of Income Planning for Schwab Center for Financial Research says that Schwab suggests “the 4% rule as a starting point for planning purposes. Then, it's important to stay flexible as you spend in retirement”.
However, the report goes on to say that “Based on Schwab's current expectations for market returns over the next 30 years, we calculate a 3% spending rate to begin retirement may be more appropriate—if you want to follow a rigid rule for spending, and have a high degree of confidence that your money will last.”
In this excellent report, one of several Vanguard has written over the years, the report states:
“For the majority of years from 1926 through 2011, the yield or income returns on a 50% stock/ 50% bond portfolio exceeded 4%. Over the last several decades, however, the yield for such a balanced portfolio has
been steadily decreasing. At its peak, in 1982, the portfolio’s average yield was 10.6%; by year-end 2011, the yield had dropped to 2.8%.” Yet, Vanguard says that a 4% withdrawal rate is still a reasonable starting point.
The report goes on to say:
“Specifically, Vanguard’s market and economic outlook indicates that the average annualized returns on a balanced 50% equity/50% bond portfolio for the decade ending 2021 are expected to center in the 3.0%–4.5% real-return range (Davis and Aliaga-Díaz, 2012). Although this level is moderately below the actual average real return of 5.0% for the same portfolio since 1926, it potentially offers support for the continued feasibility of a 4% inflation-adjusted withdrawal program as a starting point for balanced investors.”
Vanguard also has an excellent report on alternative spending strategies for those who are concerned that the constant 4% plus inflation adjusted amount in the rule of thumb may result in excessive withdrawals in poor performing markets. I discuss that report tomorrow.
David Aston, a certified management accountant and contributing editor to MoneySense magazine, wrote an article for the September/October 2012 issued titled “Make your nest egg last”. In that article he says that if you want to stick with the 4% rule, there are four strategies to limit the risk. They are as follows:
1. Cut withdrawals if you suffer losses. “Bengen encourages retirees to keep an eye on their ‘current withdrawal rate,’ which is the annual drawdown as a percentage of a portfolio’s value today (as opposed to its initial value at the time of retirement). As a guideline he suggests cutting back if you exceed the following current withdrawal rates: 5.6% at age 65; 5.9% at age 70; 6.25% at age 75; and 7.5% at age 80.”
2. Use your home equity for backup
David feels you should exclude the value of your home from your initial retirement nest egg. You can always tap the equity as back-up in case your investment returns are not what you expect. I suggest this could be at least partially problematic for many retirees who plan to downsize to fund their retirement.
3. Add annuities to the mix. David states that many experts suggest that age 70 is the sweet spot for purchasing an annuity. He notes that most annuities will pay nothing to your estate; they expire upon your death or the last spouse to die if you own a joint annuity. Many of the articles I read suggest that you consider annuities as a component part of your retirement. Moshe Milevsky in his book Pensionize Your Nest Egg
is very keen on using annuities and other products to ensure you do not
outlive your money, where you do not have a substantial pension in
retirement.
4. Invest conservatively—This is self-explanatory.
On Wednesday, I will review comments made and studies undertaken by retirement experts that feel the 4% withdrawal rate is excessive.
Set Retirement Withdrawal Rates Should Never be Used!
If you agree with Moshe Milevsky’s opinion (see his quote in Part 1) that any rule that starts with a set withdrawal rate, whether 4% or 3%, is a horrible rule, then you should just read to the end of this section and click the exit button (however, please come back for Parts 5 and 6). From what I can gather, Mr. Milevsky and many other retirement experts do not like the 4% rule because it uses a constant spending amount and does not adjust to your evolving level of wealth. By shunning a set withdrawal rate, retirees may avoid spending shortfalls where their investments underperform and will not accumulate surpluses when they outperform the market. My interpretation is that Mr. Milevsky feels you should spread your economic resources over your entire life and that your spending rate and retirement withdrawal number should not be fixed to an arbitrary level, but that your spending rate should depend upon your personal preferences and your views on longevity risks.
Mr. Milevsky may be critical of a set withdrawal rate, but he does not just point out the flaws and walk away. In his book The 7 Most Important Equations for your Retirement he provides a unique set of mathematical equations to determine your retirement needs.
I found this book innovative and as entertaining as a math book could be (Moshe uses seven historically famous people to introduce his equations). However, to be honest, I had challenges with the math, especially the final equation in Chapter 7. You may want the math wiz in the family to assist you with your calculations. I would suggest at minimum, you use Moshe’s equations to back-test whatever retirement nest egg and spending rates you arrive at.
Michael James
Before I move onto the modern safe withdrawal rate studies, I have to give a shout out to Michael James, a fellow Canadian personal finance blogger who created his own strategy, which includes holding five years of savings in a savings investment account. His "Magic Number" calculator is here. The background to his calculator is discussed in his blog post titled "A Retirement Income Strategy" and in this second post on the topic.
Modern Studies and Reports
The Bengen and Trinity studies, from which the 4% withdrawal rule originated, utilized stock market data from 1926 to 1976 and 1926 to 1995 respectively. Many commentators feel this historical data is no longer applicable in today’s world.
To help you determine if 4% is a safe withdrawal rate for you (with the limitations I noted in my first post), I’ve summarized below several current studies and reports on this topic. Some of the studies/reports continue to condone the 4% withdrawal rate or are at least accepting of using a 4% withdrawal rate as a starting point. Others feel it is excessive and if you withdraw 4%, you will be eating cat food at some point in your retirement.
If you are like me, you will probably be overwhelmed by these reports, their arguments and their data. Although you will never achieve certainty, your withdrawal percentage is the vital wildcard in trying to estimate your retirement nest egg and, you must draw a line in the sand using a percentage within your comfort zone, assuming you believe in a constant withdrawal rate strategy or a variation of the strategy.
The Studies that suggest a 4% withdrawal is still a Good Starting Point.
What Charles Schwab has to Say
In this report by Rob Williams, Director of Income Planning for Schwab Center for Financial Research says that Schwab suggests “the 4% rule as a starting point for planning purposes. Then, it's important to stay flexible as you spend in retirement”.
However, the report goes on to say that “Based on Schwab's current expectations for market returns over the next 30 years, we calculate a 3% spending rate to begin retirement may be more appropriate—if you want to follow a rigid rule for spending, and have a high degree of confidence that your money will last.”
What Vanguard has to Say
In this excellent report, one of several Vanguard has written over the years, the report states:
“For the majority of years from 1926 through 2011, the yield or income returns on a 50% stock/ 50% bond portfolio exceeded 4%. Over the last several decades, however, the yield for such a balanced portfolio has
The report goes on to say:
“Specifically, Vanguard’s market and economic outlook indicates that the average annualized returns on a balanced 50% equity/50% bond portfolio for the decade ending 2021 are expected to center in the 3.0%–4.5% real-return range (Davis and Aliaga-Díaz, 2012). Although this level is moderately below the actual average real return of 5.0% for the same portfolio since 1926, it potentially offers support for the continued feasibility of a 4% inflation-adjusted withdrawal program as a starting point for balanced investors.”
Vanguard also has an excellent report on alternative spending strategies for those who are concerned that the constant 4% plus inflation adjusted amount in the rule of thumb may result in excessive withdrawals in poor performing markets. I discuss that report tomorrow.
What David Aston has to Say
David Aston, a certified management accountant and contributing editor to MoneySense magazine, wrote an article for the September/October 2012 issued titled “Make your nest egg last”. In that article he says that if you want to stick with the 4% rule, there are four strategies to limit the risk. They are as follows:
1. Cut withdrawals if you suffer losses. “Bengen encourages retirees to keep an eye on their ‘current withdrawal rate,’ which is the annual drawdown as a percentage of a portfolio’s value today (as opposed to its initial value at the time of retirement). As a guideline he suggests cutting back if you exceed the following current withdrawal rates: 5.6% at age 65; 5.9% at age 70; 6.25% at age 75; and 7.5% at age 80.”
2. Use your home equity for backup
David feels you should exclude the value of your home from your initial retirement nest egg. You can always tap the equity as back-up in case your investment returns are not what you expect. I suggest this could be at least partially problematic for many retirees who plan to downsize to fund their retirement.
4. Invest conservatively—This is self-explanatory.
On Wednesday, I will review comments made and studies undertaken by retirement experts that feel the 4% withdrawal rate is excessive.
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information of a general nature. These posts should not be considered specific advice;
as each reader's personal financial situation is unique and fact specific.
Please contact a professional advisor prior to implementing or acting upon any
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