Debunking 4% Withdrawal Rate

Spending Safely

Advisers now concede that fluctuating conditions make rigid formulas for drawing down savings unrealistic

By Lynn O’Shaughnessy

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If you’re getting ready to retire, you may already be familiar with “the 4% solution.”

For more than a decade, financial advisers have warned retirees that draining over 4% of their nest eggs in their inaugural retirement year could ultimately lead to financial ruin.

The 4% mantra started with Bill Bengen, 60, a soft- spoken investment adviser in El Cajon, Calif., who has written a series of landmark research papers since 1994 on safe withdrawal rates. What most people don’t realize, though, is that Bengen no longer recommends the 4% rate. “The figure is stuck in the corner of people’s minds, and I don’t know how to get it out,” he laments.

Bengen now suggests that the 4% figure—actually 4.1% for a 60/40 portfolio of large caps and bonds and 4.5% if you toss in small caps—merely seems impressive when plugged into Excel (MSFT) spreadsheets. In practice, the strategy, which Bengen stopped using with his own clients about three years ago, is inflexible and unrealistic he says—and the formula is too stingy.

Bengen and other financial wonks now advocate less rigid approaches to the tricky challenge of sustaining a nest egg. “We know a lot more about [safe withdrawal rates] than we did 15 years ago,” says Jonathan Guyton, a principal at Cornerstone Wealth Advisors in Edina, Minn., who has written extensively on withdrawal issues. “What we are seeing in a relatively short period of time is quite an evolution.”

The 4% approach initially seemed to make sense. Under the plan, a retiree with a $1 million portfolio withdraws $40,000 (4%) in the first year. In subsequent years she withdraws the previous year’s amount, adjusted by the rate of inflation. So 12 months later, if inflation is 3%, she could pull out $41,200 ($40,000 x .03). If retirees followed this rule, advisers liked to say, there should be almost no chance of a portfolio being depleted within 30 years.

One expert now questioning this conventional wisdom is Michael Kitces, 30, director of financial planning for Pinnacle Advisory Group in Columbia, Md. Kitces was frustrated that the 4% rule can result in overly conservative withdrawal rates during certain market conditions and that the market’s mood at the time of the initial withdrawal could greatly affect how much money retirees can drain from their accounts for the rest of their lives.

Kitces looked at two hypothetical couples nearing retirement with $1million portfolios. Couple No. 1 retires and withdraws 4.5% of their assets ($45,000). During the next year, stocks plunge by 15%. Despite the market implosion, couple No. 1 gets to increase their next withdrawal by the inflation rate—in this example, 3%. So in the second year they pull out $46,350.

That all seems fine, Kitces says, until you examine the fate of couple No. 2. They retire one year later than Couple No. 1, but their portfolio drops with the market and is now worth $850,000. Using the same 4.5% withdrawal rate, they are limited to a $38,250 withdrawal, which is 21% lower than the other couple’s. “How can we account for a safe spending approach that produces such disparities, given identical circumstances, where the only thing that changes is the timing of the withdrawal starting point?” he asks.

Would it be possible, he wondered, to predict the market environments in which it would be prudent to boost the initial withdrawal rate? After studying historical data, Kitces concluded that a higher withdrawal rate is safe in most situations as long as adjustments are made if the stock market becomes overvalued during the first 15 years of a person’s retirement. He judges the stock market’s valuation by looking at its current 10-year price-earnings ratio. During a period when the 10-year p-e ratio has been high (over 20), a new retiree would want to play it safe with an initial withdrawal rate of 4.4% (with a portfolio split 60/40 between stocks and bonds) because it’s likely that prices of overvalued stocks will drop in coming years or appreciate at a much slower rate than the long-term average.

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