The 4%-a-year rule may not meet many retirees’ needs
By Robert Powell, MarketWatch
When you finally reach your retirement date, one of your first questions will be: How much of my savings can I spend?
The standard rule of thumb for many years was 4%. That’s how much you supposedly could withdraw every year from your retirement accounts—even on an inflation-adjusted basis—and not run out of money.
Well, today, the conventional wisdom looks less clear. That rule of thumb, which was originally based on research done by Bill Bengen in 1994, has been scrutinized, criticized and even improved upon by many, including the likes of David Blanchett, the head of retirement research at Morningstar Investment Management.
Retirement income for life
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“The good part about the 4% rule is (that) it fixes your income through time,” said Blanchett, who along with Farrell Dolan, a principal with Farrell Dolan Associates and John Olsen, the president Olsen Financial Group, spoke at a recent MarketWatch Retirement Adviser event in New York City. “It’s increased every year by inflation, but it’s based upon the initial value.”
But the problem with that approach is that it’s based on a single point in time. “You make the decision once, and you follow it for your entire retirement,” said Blanchett, who recently co-authored a white paper on the subject of optimal withdrawal strategies for retirement-income portfolios. “And that’s kind of sub-optimal, because if we think about what happens when you move through time is things change. So as you age, you’re going to live longer, potentially. If the markets go down, you could take out less income. ..The key to the 4% rule is that first it’s kind of a very basic starting point.”
According to Blanchett’s white paper, a significant amount of research has been devoted to determining how much one can afford to withdraw from a retirement portfolio, but surprisingly little work has been done on comparing the relative efficiency of different types of retirement withdrawal strategies.
Don’t buy the 4% rule
The portfolio withdrawal strategy known as the 4% rule is an appealing rule of thumb, but it can steer investors wrong, according to panelists at a MarketWatch Retirement Adviser panel discussion hosted by Senior Columnist Robert Powell.
In his study, Blanchett established a framework to evaluate different withdrawal strategies and then used that framework, in conjunction with Monte Carlo simulations, to determine the optimal withdrawal strategies for various fact patterns. Then he developed what’s called the withdrawal efficiency rate, a measure that allows researchers to quantify the relative appeal of each withdrawal strategy to determine which one is best for generating retirement income.
As part of his study, Blanchett examined five different types of withdrawal strategies and found that “the primary method employed by many (advisers), where a constant real dollar amount is withdrawn from the portfolio until it ‘fails,’” is often the least efficient approach to maximizing lifetime income for a retiree.”
So what’s the best withdrawal strategy? According to Blanchett, the best one incorporates mortality probability, where the projected distribution period is updated based on the mortality experience of the retiree (or retirees) and the withdrawal percentage is determined based on maintaining constant probability of failure. Blanchett explains it this way in plain English: “Every year the retiree is alive, figure out how much longer the retiree (or retirees) is (are) going to live. This is the ‘mortality updating’ part. You do it every year because the longer you live the longer you are likely to live. An example is: The average life expectancy for a new born is something like 74 years. The average life expectancy for someone 65, though, is 85. This difference of 11 years (age 85 vs. age 74) is based on the fact that if you’ve survived to age 65 you are likely to live longer.”
This approach, wrote Blanchett, best replicates how a financial planner would (or at least should) determine the available income from a portfolio for each year during retirement.
As a practical matter, for retirees who can’t replicate that approach, the required minimum distribution or RMD is as a reasonable alternative to the more common constant dollar and constant percentage of assets withdrawal strategies. That’s a strategy where you take the dollar amount of your retirement account and divide it by your remaining life expectancy to determine how much money to withdraw. So, if you think you’ve got 20 years left, you would take out 1/20th, or 5%.
Blanchett also noted during the Retirement Adviser event that using a systematic withdrawal program cannot guarantee that a retiree will have income for life. “”You cannot guarantee that with a withdrawal program from a portfolio without an annuity,” he said.
The Retirement Adviser panelists also urged retirees and preretirees to make sure they work with advisers who are familiar with using all the tools available for building a retirement-income plan. Some might focus solely on using a systematic withdrawal plan while others might focus solely on using annuities. And what you really need is an adviser who “understands both to have a really good plan,” said Blanchett.
Blanchett and the other panelists also noted that everyone’s situation is different. Some retirees and preretirees who have plenty of financial capital to fund their lifestyle in retirement might not need to use an annuity as part of their retirement-income plan, while others with less capital might. “The more funded you are, the more you have for your need, the less insurance you’re probably going to need,” said Blanchett. “Bill Gates doesn’t need an annuity, he can self-fund.
When annuities make sense
“The more non-discretionary expenses you have, the more you control an annuity because you want to make sure those are covered for life,” Blanchett continued. “The longer you’re expected to live, the better annuities look. So there are things you can think about that should affect your decision. But the problem is let’s say there are 15 variables that are very important. You can insert 14 one way, but that 15th then changes everything.”
Blanchett also urged retirees and preretirees who might be considering buying an annuity with guaranteed living benefits to take the time to understand the contract. And, if they are unable to understand the contract, they might consider using an immediate annuity. “If you don’t understand, go for simplicity,” he said. “Go for an immediate annuity because they tell you the payout rate. There are products that are a lot simpler than others.”
Blanchett also said it’s difficult to suggest the best way for retirees and preretirees to divvy up their assets among investments and insurance products. “There isn’t this one consistent answer,” said Blanchett.
And so for most people trying to build a retirement-income plan, the answer is this: You have to strike a balance between taking too much money early and being broke later, and taking too little money early and having too much leftover later. “I think the goal should be to kind of smooth your consumption over time,” said Blanchett. “So I think that you have to have a middle ground…you should build a plan around lifestyle changes.”
Robert Powell has been a journalist covering personal finance issues for more than 20 years, writing and editing for publications such as The Wall Street Journal, the Financial Times, and Mutual Fund Market News.