May 30, 2015 — One of the most important subjects about retirement is how much you can take out of your retirement funds. Withdraw too much too soon, and you run out of money for your old age. Take out too little, and you shortchange your fun – plus leave more than you intend to your relatives and/or the government. This article will explore some new competing theories to the popular 4% rule, which has long been viewed as the gold standard for retirement withdrawals.
One of the key assumptions about the 4% rule, which theorizes you can almost always withdraw 4% of your retirement savings every year without danger of exhausting them, was that your investments would at least earn something close to 4% over the long haul. The so called 4% rule is credited to California financial planner Bill Bengen. Sure there would be some bad years, but in the long run the better years would take care of that. The problem is that in the past 10 years it has been hard to predict how much your investments would earn. For example if you invested in bank CDs, you would not have got anywhere near 4%. If in stocks or bonds, 2008 would have produced whopping losses, although mostly recovered since then. Stocks are very high now, so there is worry about a fall. There is always the possibility of a catastrophic worst case scenario, when almost no approach is safe. Yet most people’s experience is one of underspending.
New theories are plentiful. One popular one is to adopt the Required Minimum Distribution formula from the IRS. This method has relatively modest withdrawals in the first years (starting in the year you turn 70 and 1/2 (3.65%) and gradually escalating to 15.87% at age 100. The beauty of this approach is that it plays it safe – you don’t take out much in early years, so if you are lucky enough to live a long life you get to enjoy the money.
Other approaches, and there are many, are more complicated. In a recent NY Times article, “New Math for Retirees And the 4% Rule”, the newspaper explained some of these competing strategies. Those include the Constant Inflation-Adjusted Spending, Bengen’s Floor and Ceiling Rule, and Guyton and Klinger’s Decision Rules. They all assume that the retiree has a 1$ million portfolio, is 65 years old, and is 50% invested in stocks and 50% in bonds. In general this hypothetical retiree could usually safely take out $30,000 a year without running into trouble. You can read more about these strategies in the Times article, but here is a brief summary of each.
All 3 of the theories here are basically a proposed improvement over the original Bengen 4% rule. They start with that, but go on to try to accommodate periods when returns are much better than normal, much worse, or experience big changes in inflation. If the returns are exceptional, you get to take out more than normal. But if the market tanks, you don’t take out so much to protect your principal. Likewise if the inflation situation changes drastically, you are adjusting to that. All have the goal of letting you spend as much as you can safely in a changing environment.
Constant Inflation-Adjusted Spending
Take a certain percentage from the portfolio in year 1 (such as 2.85%) and adjust that percentage every year thereafter for inflation.
Bengen’s Floor and Ceiling Rule
Take a certain percentage from the portfolio in year 1. In subsequent years that percentage could increase as much as 25% in great market years, but only 10% in bear markets.
Guyton and Klinger’s Decision Rules
Withdrawals increase to match inflation. But if the withdrawal rate ever reaches 120% of the year 1 rate, the withdrawal rate is cut. The rate could increase 10% in good market years.
What to do
As you can see from this discussion, the issue of how much to take out of your retirement assets every year is complicated. It is worthy of serious thought and a good discussion with your financial adviser to arrive at the strategy that you are comfortable with. Of course we realize this is a lucky, first world problem compared to the situation for many retirees, whose retirement savings are far less than $1 million.
Comments? Which theory are you planning on using – or do you have one of your own. Please share your thoughts in the Comments section below.
For further reading:
Which Withdrawal Strategy Should You Use in Retirement (Bob Powell- MarketWatch)
How Much Should You Take from Your Retirement Funds Each Year
You and Your IRA and 401(k): An Owners Manual