One of the biggest challenges new retirees face is the transition from working to earn money to replacing that income with retirement savings. If you have been a good financial steward — saving part of your earnings to prepare for a comfortable retirement — it can be psychologically difficult to reverse that process.
The withdrawal of money from savings can create angst for many people. Their mindset, for likely 30 or more years, has been to save money in preparation for retirement; however, when they reach that point they do not usually have a plan for how to extract it. Sure, the mechanics of getting it out are easy, you just call the bank or brokerage firm and ask for a distribution.
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Nevertheless, having a plan to know how much is safe to withdraw, so you do not outlive your money, is where the uncertainty and angst begin.
There have been many studies over the years addressing the topic of safe withdrawals, and in the financial services industry the term used is “the sustainable withdrawal rate.” You should become familiar with this concept whether you are approaching retirement or still in the process of saving money.
In 1994, William Bengen published a study on sustainable withdrawal rates. You may recognize the idea that taking 4 percent of your asset value each year is a “safe” percentage to use — this figure is a direct result of Bengen’s work. He built his study around a person retiring at age 65 and needing their money to age 95. Taking into consideration different 30-year rolling investment periods he wanted to determine how often and at what withdrawal rate people ran out of money before the 30-year mark. He determined that the safe withdrawal rate was approximately 4 percent.
The idea is a person starts with a withdrawal rate of 4 percent of the value of his/her assets in the first year of retirement. The next year, increase the prior year’s amount by the rate of inflation and do the same each following year. Increasing the withdrawals by the rate of inflation is important to protect your purchasing power. Based upon this methodology, a portfolio could last 30 years or longer. There were a few simple, but important, assumptions to go along with this theory: the portfolio was comprised of 50 percent U.S. stocks and 50 percent intermediate U.S. government bonds, rebalanced once a year.
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Bengen’s study provided the framework for many studies that have followed. These studies offer additional guidance around how the 4 percent rule should be decreased or increased under various circumstances.
A valuable aspect of the 4 percent rule is the strategy’s focus on avoiding the worst-case scenario — be it low interest rates, a market correction or any combination of events. Most planning calculators assume a steady rate of return over a lifetime or retirement period. We all know that in reality returns are very lumpy, so to a large extent, there is an element of luck in the year you retire.
If you retire into a bull market that lasts several years, everything appears easy and you will be able to take out much more than 4 percent. If you are unfortunate to retire into a period like the early 2000s or 2008, you can have significant challenges.
In his 2008 study — “Resolving the Paradox: Is the Safe Withdrawal Rate Sometimes Too Safe?” — Michael Kitces used a measure call the Shiller P/E to provide deeper guidance. Kitces did his work using an assumption of a 60 percent stock and 40 percent bond allocation. The Shiller P/E is a measure of the price-earnings ratio of the stock market calculated using the average earnings of the past 10 years. When the Shiller P/E is high that means the stock market is expensive. The reverse is true if the ratio is low. Currently, the ratio is high at approximately 26. At today’s P/E, Kitces’ work suggests a safe starting withdrawal rate to be around 4.4 percent.
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For today’s pre-retiree and retiree, the key point is to recognize that we are currently in a period on the high end of stock valuations. If you combine that with the low interest rate environment it suggests those in retirement should be cautious about how much their withdrawal rate is, and those still planning for retirement should consider bumping up their savings to create a cushion.
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How Much Can You Spend in Retirement? originally appeared on usnews.com
