Kelly Greene for the Wall St. Journal writes: Say Goodbye to the 4% Rule If the conventional wisdom no longer holds about spending in retirement, what are the alternatives? Here are three of them.
Conventional wisdom says you can take 4% from your savings the first year of retirement, and then that amount plus more to account for inflation each year, without running out of money for at least three decades.
This so-called 4% rule was devised in the 1990s by California financial planner William Bengen and later refined by other retirement-planning academics. Mr. Bengen analyzed historical returns of stocks and bonds and found that portfolios with 60% of their holdings in large-company stocks and 40% in intermediate-term U.S. bonds could sustain withdrawal rates starting at 4.15%, and adjusted each year for inflation, for every 30-year span going back to 1926-55.
Well, it was beautiful while it lasted. In recent years, the 4% rule has been thrown into doubt, thanks to an unexpected hazard: the risk of a prolonged market rout the first two, or even three, years of your retirement. In other words, timing is everything. If your nest egg loses 25% of its value just as you start using it, the 4% may no longer hold, and the danger of running out of money increases.
If you had retired Jan. 1, 2000, with an initial 4% withdrawal rate and a portfolio of 55% stocks and 45% bonds rebalanced each month, with the first year's withdrawal amount increased by 3% a year for inflation, your portfolio would have fallen by a third through 2010, according to investment firm T. Rowe Price Group. And you would be left with only a 29% chance of making it through three decades, the firm estimates.
That sort of scenario has left many baby boomers who are in the midst of retiring riddled with angst. "The mind-blowing aspect of retiring is all these years you're accumulating and accumulating, and then you need to start drawing down, and you have no idea how to do that," says Al Starzyk, a 66-year-old retired printing executive in Williamsburg, Va.
So, if you can't safely withdraw at least 4% a year from a balanced portfolio of equity and bond funds, what do you do? Here are three alternative approaches that retirement specialists say may work better to ensure your money lasts as long as you do:
Use annuities instead of bonds
Pairing the most plain-vanilla type of annuity—called a single-premium immediate annuity—with stocks, retirees can generate income more safely and reliably than if they use bonds for that piece of their portfolio, says Wade Pfau, a professor who researches retirement income at the American College of Financial Services in Bryn Mawr, Pa.
To arrive at that conclusion, he plotted how 1,001 different product allocations might work for a 65-year-old married couple hoping to generate 4% annual income from their portfolio.
Using 200 Monte Carlo simulations for each product allocation, and assuming returns based on current market conditions, the winning combination turns out to be a 50/50 mix of stocks and fixed annuities, Mr. Pfau says. If inflation accelerates more than the markets now expect, inflation-adjusted annuities would become more attractive, he adds.
"There is no need for retirees to hold bonds," he says. Instead, annuities, with their promise of income for life, act like "super bonds with no maturity dates," he says.
But immediate annuities have one big drawback: The buyer loses access to his or her savings in exchange for those guaranteed payments. In other words, if you have a sudden long-term-care need or some other type of emergency, there's no way to recapture a large chunk of cash. As a result, some retirees and their advisers are using variable annuities with guaranteed income benefits instead. These annuities allow investors to withdraw more than the set annual amount in an emergency.
Mark Cortazzo, a certified financial planner in Parsippany, N.J., typically recommends that people preparing to retire figure out their basic, nondiscretionary annual expenses and use a variable annuity with guaranteed benefits to make up for whatever portion of that total won't be covered by Social Security and any pensions. That way, they can pay their bills throughout retirement and afford the risk of investing much of the rest of their savings in stock funds, he says.
"If they've got a guaranteed check that's covering their needs, it's a lot easier for them to stick it out when there's a storm coming" in the stock market, Mr. Cortazzo says.
Follow the tax man's tables
One way to manage retirement withdrawals is to use life-expectancy tables such as the one the Internal Revenue Service uses to establish required minimum withdrawals from individual retirement accounts. This works almost as well as more-sophisticated modeling done by retirement-research experts at Morningstar Inc., those experts say.
IRA distributions don't have to start until age 70½, but the IRS publishes life-expectancy numbers for earlier ages as well in Appendix C of Publication 590 at irs.gov.
Here's how it works: Using your nest-egg balance as of Dec. 31 of the previous year, you would look up your age in the IRS table and divide your account balance by the life expectancy given for that age. Let's say you saved $1 million and retired at age 62. Your life expectancy, according to the IRS, would be 23.5 years. So, you would divide $1 million by 23.5, arriving at a withdrawal amount of $42,553. If your account balance grew the following year by 5% to almost $1.01 million, you would withdraw $44,287 (the new balance divided by your 63-year-old life expectancy of 22.7 years). But if your savings shrank 5% to $909,575, you could withdraw only $40,069.
The downside is that the withdrawal amount will fluctuate. But you would have a reasonable shot of outlasting your savings, particularly for people with life expectancies of less than 25 years, says David Blanchett, Morningstar's head of retirement research.
And while your withdrawal amounts could shrink in any given year, this is a more flexible approach than one being recommended by some retirement-planning pros: lowering the initial withdrawal rate to the 2% to 3% range and then adjusting for inflation each year. With 4% a stretch for many retirees to live on, even with the help of Social Security, 2% could prove impossible. The life-expectancy approach may also result in withdrawals of less than 4% in some years—or even every year—but it doesn't call for withdrawals below 4% every year regardless of what the markets do.
Peg your withdrawals to stock valuations
If stocks are pricey when you retire, suggesting lower returns over subsequent years, you should be cautious about how much you pull out; it's clearer sailing if stocks are at bargain prices. Hence, the approach devised by Michael Kitces, research director at Pinnacle Advisory Group Inc. in Columbia, Md. He determines what he considers safe withdrawal rates by using the P/E 10 for the Standard & Poor's 500-stock index. The P/E 10 is a measure of current stock prices relative to the companies' average inflation-adjusted earnings over the past 10 years.
When using a portfolio of 60% stocks and 40% bonds, he found that three rules worked for determining an initial withdrawal rate for 30 years of retirement and adjusting withdrawals each year for inflation. Mr. Kitces says he focused on returns during the first half of a projected 30 years of retirement, because preserving your nest egg for the first 15 years means you would be in good shape for the rest.
His rules: If the P/E 10 is above 20, in which case he considers the market overvalued, you would withdraw 4.5% in the first year of retirement, adjusting that initial amount for inflation every year thereafter. If the benchmark falls between 12 and 20, where he considers the market fairly valued, the initial withdrawal would be 5%. If it's below 12, or undervalued, you can pull out 5.5% the first year. (If you aren't comfortable taking out that much, you might use lower percentages but incorporate the same approach.)
You can track the P/E 10, based on research by Robert Shiller, a professor at Yale University, at multpl.com/shiller-pe. The current number is 23.4, meaning a first-year withdrawal of $45,000 if you're starting retirement now with a $1 million nest egg.
Followed Up with Below
Kelly Greene for the Wall St. Journal writes: An article in the March Investing in Funds & ETFs report noted that some retirement-income experts are throwing out the so-called 4% rule—the conventional wisdom that you can take 4% from your savings the first year of retirement, and then that amount plus more to account for inflation every year after that, without running out of money for at least three decades. That article laid out other approaches that might make it more likely that your nest egg will last as long as you do—including replacing the bonds in your portfolio with annuities and using life-expectancy tables to determine each year's withdrawal amount.
Here are answers to three questions that readers have asked about the 4% rule for retirement and the new approaches:
Q: When you talk about taking a 4% withdrawal from your portfolio, are dividends included in that 4%? My average dividends (not reinvested) are 2%. Does that mean it would be safe to withdraw 6% including dividends?
A: When academics are trying to figure out just how much income retirees can extract from their savings, they commonly look at what is known as the "total return" of a given investment. The total return includes dividends paid on stocks and coupon payments for bonds.
They typically assume that such income is reinvested in the portfolio—not that the retiree spends it. So, dividends paid by any stocks held in retirement accounts would be assumed to be immediately reinvested in the portfolio—not used as an additional income source.
The 4% rule would count those dividends toward the total that could be safely withdrawn.
Q: You mention inflation-adjusted annuities. What are those and how can I locate them?
A: Wade Pfau, a professor who studies retirement income at the American College of Financial Services in Bryn Mawr, Pa., recently found in his research that by pairing the most plain-vanilla type of annuity—called a single-premium immediate annuity—with stocks, retirees can generate income more safely than with bonds for the same portion of their portfolio. Inflation-adjusted annuities are nothing fancy. They are simply those basic annuities with a rider attached that provides an inflation hedge offered through such insurers as American General Life Cos. and Principal Life Insurance Co.
Of course, there's a trade-off: Adding such protection will lower the initial monthly payments.
Q: Why did you choose the life-expectancy table that the IRS uses for distributions from inherited IRAs?
A: A strategy suggested by David Blanchett, head of retirement research for Morningstar Inc., is to use a life-expectancy table, such as the one the Internal Revenue Service uses to establish required minimum withdrawals from inherited individual retirement accounts. (It's Table I in Appendix C of IRS Publication 590 atirs.gov.)
But finding the right life-expectancy estimates to use out of the hundreds of actuarial tables available is a bit like playing Goldilocks.
Mr. Blanchett said that he prefers Table I to Table III, which is used more commonly for IRA owners' retirement withdrawals, because he considers Table I to be a better, middle-of-the-road benchmark for healthy, well-educated retirees. Table I puts the life expectancy of a 70-year-old at 17 years. Table III says 27.4, which Mr. Blanchett says is too long. "If you overestimate life expectancy, you're reducing your consumption too much," he explains.