Did you have an allowance as a child? If so, do you remember trying to come up with ways to get your parents to give you a raise? Before having a job, most of us had to rely on birthdays, holidays, and allowances (for the lucky ones) to get the cash we needed to buy that action figure, remote-controlled car, Barbie Corvette, or Slurpee from 7-Eleven. I remember thinking to myself, "When I have a job, I'll buy all the Legos and candy I want!"
One of the unfortunate realities of life is that after working for decades and buying all the Legos and Skittles our hearts desire, we have to go back on an allowance! That's right—if you want your piggy bank to jingle when you shake it, you can't just blast through your savings in the first five years of retirement. You have to make your savings last for the duration of your retirement, however long you expect that to be.
The easiest way to approximate how long your retirement nest egg needs to last is to subtract your retirement age from your life expectancy. Easy enough, but the more important question is how can you make your retirement savings last that long? The answer depends on a lot of factors, one of which is the annual rate at which you make withdrawals from your savings.
The Shift from Pensions to Account-based Plans
Until the late 1970s, employer pension plans were the primary vehicle for retirement funding. Now, 95% of Fortune-500 employers offer only an account-based plan, in which employees are responsible for their own retirement funding. When pensions provided most of retirees’ income needs, retirees typically covered shortfalls by taking a fixed monthly amount from savings.
As the responsibility for retirement funding shifted from employer to employee, the fixed monthly withdrawal became inadequate for managing a retiree’s need for income. Academics and finance professionals started to consider the question of how much money retirees could expect to get from their retirement savings.
Good: The 4% Rule
The goals of a successful withdrawal strategy are to maximize the use of the funds available, while at the same time, ensuring that the funds last as long as the retiree.
In 1994 Bill Bengan addressed this question in his paper "Determining Withdrawal Rates Using Historical Data.” His findings became known as “the 4% Rule.” The simplified version states that a retiree, planning to live for 30 years, investing his accounts in a 60% stock and 40% bond mix, can safely withdraw 4% of the starting account value in the first year of retirement, and have the withdrawals increase to keep up with inflation each year.
Example – The 4% Rule
Mr. Money retires at age 65 with $1,000,000 in savings. According to the 4% Rule, Mr. Money can withdraw $40,000 from savings in his first year of retirement ($1,000,000 x 4%). The next year, he will take out $40,000 plus an amount to compensate for inflation. If, during that first year of retirement, price inflation was 2.5%, Mr. Money would then take out an extra $1,000 ($40,000 x 2.5%) for a total of $41,000.
This rule is an improvement over the fixed-dollar withdrawal method, but still has limitations. First, it is based on a 90% probability of success. Second, while 30 years of retirement is a good conservative rule of thumb, the 4% Rule does not adjust for changes in the likelihood of dying sooner or living longer, as you progress through retirement. Third, since the initial withdrawal amount, and all subsequent amounts, are based on the account value at a certain point in time, the withdrawal amount is unduly affected by short-term investment performance.
Better: Dynamic Withdrawal Strategies
Since the 4% Rule's inception, there has been more work done on safe withdrawal rates, most of which has suggested the benefits of using a dynamic withdrawal rate that factors investment performance into the equation. The net effect of dynamic withdrawal strategies is that they allow for a higher-than-4% initial withdrawal rate by using a constant percentage instead of a constant dollar amount. In its most basic form, a dynamic withdrawal strategy would look like this:
Example – Dynamic Withdrawals
Ms. Mo’ Money retires at age 65 with $1,000,000 in savings. She withdraws $55,000 ($1,000,000 x 5.5%) at retirement to cover her living expenses for the next year. Unfortunately, during the next year her investments lose 3%, leaving a balance of $916,650. Under the dynamic withdrawal strategy, Ms. Mo’ Money’s next withdrawal will still be 5.5% of the portfolio value, but the amount will be reduced to $50,416.
Other variations of this theme exist, some setting floors and ceilings, some allowing an inflation adjustment after years with positive performance while eliminating inflation adjustments after negative years. The take-away is that a dynamic strategy more appropriately aligns withdrawals with the performance of the accounts funding them. Using the first year of retirement as a baseline, in years after positive returns the retiree essentially gets a bonus, but in years following negative returns the retiree receives a pay cut.
All of these strategies are more effective than no plan at all. They’re certainly more effective than taking withdrawals during retirement with no consideration of the sustainability of the funding source. However, we believe that you can improve on both the 4% Rule and dynamic withdrawal strategies.
Best: A Holistic Approach
When developing financial plans with clients, we factor in many variables, including current spending levels, future spending levels, periodic expenses, one-time expenses, inflation, current savings balances, and assumed rates of return. We examine the probability of a successful retirement considering the things that concern you—for example, if you spend more, or retire earlier, or have lower investment returns. And we take it a step further, stress-testing the outcomes under adverse market conditions. By the time we’re done, you have a plan you can count on.
Then we revisit the assumptions periodically with clients to factor in changes and new expectations. By revising and updating spending and other assumptions as they change—and they do change—we help people create a sustainable path to reaching their retirement goals.
Finding the most efficient ways to help clients reach their goals is one of our strengths at Grubman Wealth Management. We actively search for ways to improve the service we provide and we take great pride in our approach and its results. If you would like to know more about how these strategies would impact your retirement, please contact us. You can also find us on Facebook, Twitter or LinkedIn.