Nov 20, 2012 — New research suggests that the traditional rule of thumb for how much you can safely take out of your retirement funds, 4% per year, is not the ideal tool for the job. Originally popularized by Bill Bengen in 1994, it was at least partially based on the assumption that traditional stocks and other investments would return 6% or more over the long haul. As reported by Robert Powell at WSJ MarketWatch in “Retirement Income: What’s Wrong with the 4% Rule” and the Center for Retirement Research in “Can Retirees Base Wealth Withdrawals on the IRS’ Required Minimum Distributions?”, several exciting new theories challenge the traditional 4% orthodoxy.
Not so long ago most retirees didn’t have to worry about how much to take out of their retirement savings. That’s because they had pensions plus social security – retirement savings just weren’t that important. But today in the age of 401k and IRA savings the question is absolutely critical – what you have in those accounts has to last as long as you (and your spouse) do. This article will cover some new and emerging ideas about the age old question – “How much can safely take out of your retirement account – and not run out of money”!
Balancing Income with Safety – Competing Approaches
Managing retirement wealth involves trading off the enjoyment of spending one’s assets on consumption against the risk of spending too much and prematurely depleting one’s resources. The first of the competing theories was explained by David Blanchett,the head of retirement research at Morningstar Investment Management, at a recent Retirement Advisor conference sponsored by WSJ MarketWatch. In Blanchett’s paper he compared 5 competing ways to determine the optimum retirement spending rate. The 4% rule, a constant percentage method, is the 2nd of those – (others include constant dollars and remaining life expectancy). The good thing about the constant income or constant percentage approaches is that your income will be fairly stable over time, since you decide at the beginning how much you were going to take out each year. But according to Blanchett a better theory is the “Probability of Failure Mortality Updating” method. In that approach you continue to recalculate the withdrawal amount based on your expected longevity, adjusted for the “failure” risk that your remaining investments might tank. A simple explanation is that at age 65 you have a life expectancy of around 85, so you need to take that length of time into account in your distributions. But, once you make it to 75, you have fewer years to worry about, so you can withdraw at a much higher rate. A drawback is that younger retirees might be able to use the money more than older ones, although not if you have expensive medical problems or have to move to assisted living.
The second theory like we like even better for its simplicity was researched by Wei Sun and Anthony Webb of the Center for Retirement Research at Boston College. Their theory builds on the RMD (Required Minimum Distribution) method required by the IRS. The RMD requires that when you reach age 70.5 you have to begin disbursing your 401k and/or IRA according to a percentage that changes with your life expectancy each year.
The required IRS distribution percentage starts at 3.13% at age 65 and goes to 15.87% at age 100. The authors also explain competing withdrawal strategies that a retiree might consider. Those include the “interest only” approach (withdrawing only the interest earned on your retirement account), the fixed percentage, and the IRS’s RMD approach, among others. Sun and Webb believe that the RMD approach is superior to the 4% rule because it continually adjusts for life expectancy.
A Hybrid Approach That’s Even Better
Sun and Wei believe there is a hybrid of the RMD strategy that works even better. According to them the highest performing retirement withdrawal approach modifies the RMD by adding in interest and dividend income, but not capital gains. This modification gives extra income to younger retirees without jeopardizing future losses to inflation. Here is how they explain it in their paper:
“To illustrate, a 65-year-old couple with financial assets of $102,000 who received $2,000 of interest and dividends in the last year, would spend $5,130: the $2,000 in interest and dividends, plus 3.13 percent (the age 65 Annual Withdrawal Percentage under the RMD strategy) of $100,000. In contrast, a household following the unmodified RMD rule would spend just $3,130.”
The Bottom Line
If you are fortunate to have saved significant amounts of money for your retirement, congratulations. You have done the hardest work. Now you have to make a decision on the optimum way to spend your saving so as to maximize income and minimize the risk of running out – and that decision is not as cut and dried as you might have thought. As this research points out, simply deciding once and forgetting about it strategies aren’t nearly as effective as careful year by year review of the situation. Making financial decisions of this much importance are difficult, so we always recommend that you consult a qualified professional before acting (but make sure they know about this research). Good luck!
For further reading:
What is Your Number?
Is Even $1 Million Enough?
Can You Afford to Retire and What If You Don’t Like the Answer
Firecalc is a free tool that gives you probabilities of success against different rates of return.