A popular rule of thumb is a good starting point, but an update is needed to help Americans plan for retirement in 2015.
In the realm of investing, rules of thumb are everywhere. Save 10 percent of your income. Put at least 20 percent down. Deduct your age from 100 to determine an appropriate stock allocation.
Few guidelines have had as much impact on retirement planning as the so-called 4 Percent Rule, which was developed two decades ago by financial planner Bill Bengen. His premise was widely embraced because it was both simple and effective: retirees who split their portfolio between stocks and bonds and withdrew 4 percent of their initial retirement account balance each year could have a paycheck to cover living expenses for 30 years. This guideline makes it easy enough to work backward to determine a “magic number” needed in order to retire.
The 4 Percent Rule has guided planning for countless retirements over the years. But while the underlying principles are timeless, many of the specific implications are in need of an update. Below are several charts illustrating the potential shortcomings of a simplified rule of thumb such as the 4 Percent Rule in retirement planning.
Problem #1: Real Returns on Bonds
The 4 Percent Rule has been shown to be very effective — as measured by potential failure rate — on a backward-looking basis. It is also, however, very sensitive to a few key assumptions, the most relevant of which is current bond yields. Today, yields on Treasurys are several hundred basis points lower than they were in the mid-1990s, and have been stuck at record low levels for much longer than many expected.
The impact on retirement strategies should be clear enough: materially lower bond yields may translate into lower real returns for a 50/50 portfolio.
In a 2013 paper, Michael Finke, Wade Pfau, and David Blanchett specifically examined the impact of low interest rates, and considered the possibility that bonds would deliver near-zero returns over an extended period of time.
If real bond returns are assumed to be zero, the failure rate of the 4 Percent Rule skyrockets from just 6 percent using historical averages to 33 percent. If real returns on bonds are assumed to be -1.4 percent, the 4 Percent Rule fails in more than half of simulations.
Problem #2: Longer Life Expectancy
It is no surprise that Americans are now expected to live longer than at any time in history. Life expectancy has been climbing since the 1920s, and is expected to increase for the foreseeable future.
The following table from the Social Security Administration shows the historical and projected life expectancy at birth for Americans.
While the average life expectancy is ticking up gradually, the number of Americans expected to live past 100 will likely surge in coming decades. The following chart shows the expected number of Americans living past the age of 100.
By the year 2050, it is expected that 378,000 Americans will be age 100 or older. In addition, another 8 million will be between the ages of 90 and 100.
This trend has very clear implications for the 4 Percent Rule: the 30-year retirement period contemplated may no longer be accurate for many Americans. In order to accommodate an extended retirement, returns will need to increase or drawdowns will need to decrease.
Problem #3: Sequence of Consumption
Most rules of thumb, including the original 4 Percent Rule, are entirely theoretical and don’t consider the numerous complications introduced by human behavior.
One such consideration relates to the distribution of account drawdowns; while the 4 Percent Rule assumes a steady rate of consumption throughout retirement, the evidence suggests that expenditures are incurred unevenly. Specifically, most retirees start off retirement with a relatively high level of spending — perhaps splurging on travel and other items that they had been anticipating for years. Spending gradually drops off into the middle of the retirement period, before increasing near the end as health care-related costs become more substantial.
Investors who “front load” their retirement expenses accelerate the depletion of retirement assets, especially if higher returns coincide with the periods of higher spending. While the timing issues related to a more realistic drawdown pattern are relatively minor, they certainly introduce another wrinkle to retirement planning.
Problem #4: Underspending
In any exercise that involves a wide range of potential values for key assumptions (e.g., stock market returns), a wide range of potential outcomes will emerge. When the focus is on avoiding a certain worst case scenario (i.e., running out of money), the majority of possible outcomes will end up with significant room for error.
The following chart summarizes the possible outcomes from a modified implementation of Bengen’s 4 Percent Rule that involves changing withdrawal rates based on market performance. In order to avoid running out of money (i.e., keeping the worst case scenario above $0), investors will most likely end up with a significant account balance.
Tweaking the 4 Percent Rule
Bengen’s 4 Percent Rule has not remained untouched since its creation. Several researchers and financial planners have modified or expanded the premise:
- Michael Kitces developed a series of changes to the withdrawal rate to account for factors such as expenses, retirement time horizon, and tax status; and
- Jonathan Guyton and William Klinger researched potential modifications to withdrawal rates based on market performance.
For Americans fortunate enough to be thinking about retirement, the 4 Percent Rule can serve as a useful guidepost; it certainly provides a reasonable formula for making a rough estimate of the minimum funds needed for retirement. But it’s hardly the end of the conversation, especially in an extended era of low interest rates.
About the Author: Michael Johnston
Michael Johnston is senior analyst for Fund Reference, and also serves as COO of parent company Poseidon Financial. His investment expertise has been featured in The Wall Street Journal, Barron’s, and USA Today, among other publications. He resides in Chicago.