Worried About Running Out of Money?

Rethinking the 4% withdrawal rule.

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Money in a Bird's Nest The yield on 10-year Treasury notes recently dipped below 1.5%, while at the same time, the S&P 500 Index recorded a 10-year average return of 5% (period ending June 30, 2012). Many economists are predicting that we may be facing a time of increasing inflation.

Such a scenario is leading many baby boomers to wonder how much they will be able to withdrawal from their retirement portfolios. Nearly 20 years ago, Financial Planner William Bengen tried to answer this same question. His study on the returns for stocks and bonds going back to 1926 attempted to determine what rate of withdrawal could be sustained through 30 years of retirement. He published his study in 1994 (“Determining Withdrawal Rates Using Historical Data,” Journal of Financial Planning, October 1994), concluding that a first-year withdrawal of 4% that was adjusted each subsequent year by the rate of inflation was sustainable.

The study became widely known as “The 4% Rule.” Bengen followed up his research by adding additional asset classes and concluded in a later study (“Conserving Client Portfolios During Retirement, Part III,” Journal of Financial Planning, December 1997) that the actual sustainable-withdrawal rate was 4.5%. Subsequently, professors at Trinity University picked up on the research and examined various combinations of stocks and bonds with different withdrawal rates. Many retirement planners use Trinity Study research (“Retirement Savings: Choosing a Withdrawal Rate that is Sustainable,” by Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz/AAII Journal, February 1998) as the basis of their asset-allocation recommendations.

Considering the low investment returns of the past decade, is this research still a valid basis for retirement plans in 2012? Mr. Bengen recently updated his research to try to answer this question. The worst-case scenario with a completed 30-year period would have been the person who retired at the beginning of 1969 – the 1970s began with a devastating bear market that didn’t end until 1982. Starting with a 4.5% distribution in the first year, the retiree’s withdrawals would have reached a peak of 12.5% of principal before the bull market took off in the 1980s. Mr. Bengen concluded: “The damage done in the first 12 years, primarily from high inflation, was irreversible.” Using the 4.5% initial-withdrawal rate, the 1969 to 2000 portfolio was the only one of the 57 periods of 30 years to exhaust itself.

Is this period comparable to the last decade? The retiree who began his or her withdrawals at the beginning of 2000 faced an equally devastating bear market in the first three years, followed by an unprecedented second bear market in the 2008 financial crisis. However, inflation was relatively tame during the past decade, so the highest withdrawal rate only reached 5.9% – less than half of the peak for the 1969 retiree. It would appear that the 2000 retiree still has a good chance of sustaining another 18 years of withdrawals from his or her portfolio. (Source: William Bengen, “How Much Is Enough?,” Financial Advisor Magazine, May 2012)

The challenge for the 2000 retiree is not the beginning years, but what the next 18 years of retirement bring in terms of investment results. If stock-market returns revert back to their historic average of 10% per year and inflation remains in check, the sustainability of the 4.5% withdrawal rate will hold. However, that is a question no one can answer.

We can learn some valuable lessons from the 1969 retiree scenario. Allowing the annual withdrawal rate to reach 12.5% caused too much principal to disappear before the great bull market of the 1980s got underway. Our counsel to retirees is to never let annual withdrawals exceed 6% of their principal. Small reductions in spending can go a long way toward assuring that your principal stays intact for the long run.

Another approach is to begin with a smaller initial withdrawal. We prefer keeping it to 4% at the beginning of retirement. The smaller initial withdrawal gives you greater flexibility and room for a market decline without the need to reduce spending to stay below the 6% maximum level. Dimensional Funds’ research (Matrix Book 2012, Dimensional Funds) shows that the worst one-year period for a 60% stock/40% bond portfolio was the period March 2008 to February 2009, which resulted in a loss of 32.1%. A retiree who began distributions at the beginning of this period would have a distribution rate of 5.9% at the beginning of the second year. No reductions would have been needed.

No one knows what the future holds for the stock market. Many argue that today, the S&P 500 Index is fairly valued or even “cheap” by historical standards. The earnings on the companies in the S&P 500 have nearly doubled over the past 10 years, while the index itself has barely moved. The dividend yield for the index is more than a half-percent above the yield on the 10-year Treasury, which is unprecedented. A bull market like we had from 1982 to 1999 may be just waiting to take off, but many investors will be reluctant to take a big position in stocks after the two bear markets they went through in the last decade.

In summary, the 4% rule appears to be working for now. The key to your success in retirement will be to remain vigilant of your withdrawal rate in down markets and disciplined with your spending when you need to be. Put off big expenditures when you can until the money already has been earned during a good market. Stick to your investment strategy and don’t let the current investment fads lead you astray.

This article originally appeared in the November 2012 issue of Lancaster County magazine

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