Retirees relying on a popular strategy for drawing money from their portfolios may find the well running dry far sooner than expected. It may be time for them to find a more reliable approach to tap their savings.
Many retirees and financial advisers use the "4% rule" to calculate how much to spend from a portfolio each year in retirement. The rule is simple: Retirees who spend 4% of their initial wealth from a balanced stock-and-bond portfolio, adjusting the dollar amount annually to keep pace with inflation, can be highly confident that their portfolio will survive 30 years.
But researchers lately have raised troubling questions about whether the 4% rule holds up under today's market conditions. Much of the academic research supporting the rule is based on long-term average returns for stocks and bonds. As retirees know all too well, today's bond yields are anything but average. Intermediate-term government bonds delivered average annual returns of 5.5% between 1930 and 2011, according to Morningstar's Ibbotson Associates, but yielded less than 1% at the end of 2012.
Those low yields may mean parched conditions for retirees relying on the 4% rule. In a recent study, researchers from Morningstar, Texas Tech University and The American College analyzed drawdown strategies using a model designed to reflect today's expectations for future stock and bond returns. For a portfolio of 40% stock and 60% bonds, the 4% rule has just a 48% chance of success over a 30-year period, the researchers found. A retiree who wants a 90% chance that his money will last for 30 years would have to dial his withdrawal rate back to 2.8%. Or, if he wants the same dollar amount of spending that he would have received using the 4% rule, he will need to start retirement with 43% more savings.
To be sure, bond yields won't remain low forever. The study's model accounts for that fact, allowing yields to drift back to long-term averages over a period of years. But returns in the early years of portfolio drawdowns have a disproportionate impact on the portfolio's longevity, and that spells particular trouble for people just entering retirement. The findings "are a wake-up call" for retirees, says David Blanchett, head of retirement research at Morningstar Investment Management and co-author of the study.
The study is just the latest in a series of recent arguments against the 4% rule—and even against the very concept of a "safe" withdrawal rate. Such rules of thumb are fundamentally flawed, some critics say, because they seek to match a relatively volatile stock-and-bond portfolio with a spending amount that remains constant, in inflation-adjusted terms, year after year. Under such rules, moreover, there's no link between the annual spending amount and retirees' actual expenses. And a portfolio's chances of surviving a fixed 30-year period aren't all that relevant, some argue, because what retirees really want is a portfolio that lasts a lifetime—no matter how long or short that may be. Here's a look at what works—and what doesn't—when it comes to stretching a nest egg over a long retirement.
Build a Floor
You can't predict your life span, your total retirement spending or your future investment returns. But you can predict with relative certainty your basic retirement expenses, such as utilities, food and clothing, as well as the amount of income you'll receive from guaranteed sources, such as Social Security, pensions and annuities. Match your essential retirement expenses with your guaranteed income sources, and you've gone a long way toward building a more secure drawdown strategy—without relying on any rules of thumb.
Fred Webster, 57, is hoping to retire early and has calculated that his fixed expenses, such as utilities and property taxes, will be less than $1,000 a month. If he claims Social Security at 62, he'll get about $1,400 in monthly benefits, he says, or at least $2,400 monthly if he delays claiming until 70. Webster, an auto-parts manufacturing worker in Plymouth, Ind., can also tap a profit-sharing plan, a Roth IRA, a taxable brokerage account and rental income from his upstairs apartment to meet nonessential retirement expenses. "I compartmentalize my income," he says, adding that he's prepared to live without frills if his investments tank.
Online budgeting tools such as Mint.com can help you tally your spending and separate the essential from the nonessential expenses. Next, consider ways to maximize the rock-solid income sources that can help cover your essentials—starting with Social Security.
While low bond yields have undermined the 4% rule, they reinforce the value of delaying Social Security for many retirees. For each year you delay claiming Social Security benefits beyond full retirement age, you get an inflation-adjusted benefit boost of 8%. Compare that to the inflation-adjusted yields currently available in the bond market—specifically, on Treasury inflation-protected securities. They're negative for maturities of ten years or less. "The government's offer is pretty good relative to current interest rates," says Jason Scott, managing director at retirement-advice firm Financial Engines' Retiree Research Center.
Retirees who find that their Social Security, pensions and other guaranteed income sources won't cover basic expenses should consider immediate annuities to fill the gap, retirement experts say. Wade Pfau, professor of retirement income at The American College, a Bryn Mawr, Pa.–based institution for financial professionals, recently went in search of the optimal portfolio for retirees seeking to meet spending goals while preserving a given percentage of retirement assets at death. His research, which also factored in today's low-yield environment, found the best outcomes were produced by portfolios consisting of stocks and single-premium immediate annuities. Portfolios consisting of just stocks and bonds produced the worst outcomes.