In today’s world everything comes with a “rule of thumb”. It’s a way to simplify a more complex formula into an easy-to-remember application. “If you spend 4% each year from your investment portfolio, you won’t run out of money.” What is 4% based on and will it work for you?
In recent years, many media outlets have presented articles to help soon-to-be retirees plan for their retirement income needs. In doing so, they often leave out key points from the research pioneered by financial planner, William (Bill) Bengen. In 1994, he authored a paper in which he set out to explain how much a new retiree can safely withdrawal from their accounts in order to ensure portfolio longevity.
Two decades later this research has been thrust into the mainstream as an absolute rule. Given your specific situation, is 4% too much or too little? It depends on many variables as explained below.
Asset Allocation Makes a Difference
Bill Bengen’s original research specifically looked at the level of equities necessary to maximize portfolio longevity. This is not simply highest return, but the optimal balance between risk (volatility) and return. Bill’s research concluded that a portfolio needed to have an allocation of 50% to 75% equities for best results. It is the equity portion of the portfolio that will allow for continued growth of the assets. If you had a portfolio of all bonds, based on historical data, you would have very little growth in your portfolio. Likewise, if your portfolio is 100% stocks, the occurrence of multiple down markets while withdrawing 4%, could be devastating. This means that for Bill Bengen’s 4% withdrawal rule to work, your portfolio’s asset allocation needs to be at least 50% in stocks.
Exactly How Long Can This Last
What was Bill Bengen’s definition of longevity? According to the research, the original longevity period was assumed to be 30 years. This of course makes sense if you are an average American retiring at the age of 62 and living to the age of 80. With an extra ten years or so, Bill’s formula seemed conservative enough. But what if you retire in your 50s? What if good health runs in your family and you plan to see your 90s? Then 4% may not be the best withdrawal rate for you.
What about Taxes?
Simply put – taxes are not accounted for in the numbers. Bill stated in his original paper that all retirement funds were assumed to be in tax-deferred accounts (401k, 403b, IRA). Whenever money is withdrawn from a retirement account, it is subject to taxation. Since the applicable tax rate is not the same for all retirees, it was easier for Bill’s formula to assume that taxes would be paid from other sources or that the 4% would cover both spending and taxes.
What about Other Income Sources?
If a new retiree has other sources of income, such as a pension or Social Security, he/she may be less dependent on an investment portfolio to meet retirement spending needs. For example, let’s assume you plan to spend $5,000 a month in retirement, but you will receive $4,000 in monthly pension and Social Security benefits. This leaves only $1,000 in necessary portfolio withdrawals. Now assume your spending is the same, but you have no pension and your Social Security is only $1,000. This would require $4,000 to be withdrawn each month from your investment portfolio. Obviously, the more income generated by other sources, the less required from the investment portfolio. In the first scenario, you may need less than 4% from your retirement accounts; however, in the second case, 4% may not be enough.
While a “rule of thumb” can provide general guidance, it cannot account for all the variables. When it comes to determining what you need in your retirement portfolio to allow you to live the lifestyle you desire without the fear of running out of money, you don’t want to leave the calculation to a simple “rule of thumb”. Seek advice from a qualified advisor.
Contributions were made to this article by Ryan Jeffries, CFP®, a Financial Planning Coordinator at Bedel Financial Consulting, Inc.