This rule, developed twenty years ago, is used to forecast how much people can spend annually in retirement without running out of money. Let’s say a couple has $1,000,000 and has just retired. The rule says if they spend $40,000 (4%) from the portfolio and increase this annual withdrawal by the inflation rate, their $1 million nest egg should last for the rest of their lives.
Historically, an average annual return on a balanced allocation strategy portfolio was roughly 7% from 1970 until 2014, while annual inflation was 4%. Hence, a real return of 3%. The conditions during those four decades are different from today. The decades of the ’80s and ’90s produced average equity returns close to 20% per year. The bond bull market produced returns of almost 9% per year for the last three decades. During this time, the “rule” could have worked fairly well for some people. Today, however, there are a number of problems with this rule.
First, inflation forecasted returns and longevity have changed greatly. Inflation has been negative over the last twelve months and has averaged less than 1% per year over the last three years. Forecasted returns, of course, vary widely and no one can predict the future. A conservative estimate might be a 2% real return (3% nominal less 1% inflation, or 5% nominal less 3% inflation). Longevity is increasing. Hence, for many people, their calculations should be based on an eventual age of 100.
In an article from this past Sunday’s NYT, Professor Wade Pfau at the American College of Financial Services put it this way: “Because interest rates are so low now, while stock markets are also very highly valued, we are in unchartered waters in terms of the conditions at the start of retirement and knowing whether the 4 percent rule can work in those cases.”
Second, the 4% rule never took into account non-linear spending patterns of retirees, other goals, other retirement resources, asset allocation, taxes and stress testing the plan.
There’s a much better way to do this, though it takes more thought and time and a disciplined process. For those who value their financial future, it’s worth the effort. Here are some of the elements that you need consider:
Start with your goals. At what age do you want to achieve financial independence (freedom to retire)? What will be your likely spending patterns during retirement? What will your housing be? What will be your likely health care costs? Are there any other needs, wants or wishes you have for the future?
Retirement resources. The calculation needs to include not only the investment portfolio, but also other income sources, such as social security, pension, rental income or part-time work. The calculation also needs to review all assets, not simply the investment portfolio, and determine the amount, if any, of proceeds from the sale of those assets that could be used in the future to fund goals.
Asset allocation. Varying allocations will likely produce varying results of returns and volatility. The plan should be calculated using the appropriate allocation strategy. Returns should be calculated in two ways- historical and forecasted.
Taxes. Income taxes can have a huge impact on a plan. Allocation of investments into appropriate (taxable, qualified, Roth) accounts can make a real difference. Tax-efficiency throughout the plan is imperative.
Stress Testing. The calculations need to be done using a “stochastic” process such as Monte Carlo simulation rather than a linear one. A Monte Carlo simulation is a tool for estimating probability distributions of potential results by allowing for random variations over time. The world does not operate in a straight line and linear projections can be greatly upset (and therefore of little value) when outliers come into play. In addition, stress testing involves looking at the potential impact of negative factors in the future, including living longer, social security cuts, lower than expected investment returns, and/or large health care costs.
In short, the old 4% withdrawal rule is not a good way to predict whether or not you will fulfill the goals you have for you and your family. However, there is a process that can provide reasonable assurance and one you should expect from your wealth manager, like DWM, as part of their package of services for you. It can be a little complicated but should be customized for your particular situation. It will take some time and effort. It requires discipline and monitoring. However, if you value your financial future, it’s well worth the effort.