With today’s low interest rates and an uncertain economy, Jim Phillips wondered whether he had enough money for a secure retirement. “I thought I was okay, but I had that little bit of doubt,” says the 64-year-old (whose name we’ve changed). He was thinking last year about retiring from his job as a clerk with a transportation company in Toronto. He wasn’t sure that his investment portfolio could sustain the annual withdrawals he was planning to make once his paycheque was gone, so he sought the help of a financial planner.
This difficult investing environment is prompting retirement experts to ask the same question. Some doubt whether traditional guidelines about how much you’ll need to retire can still be relied on.
One popular rule-of-thumb says if you retire at 65 you can withdraw about 4% of your initial nest egg each year—adjusted annually for inflation—and expect your portfolio will last at least 30 years. That may not seem like much: after all, it’s just $2,000 a month (before taxes) on a portfolio of $600,000. Yet some retirement researchers suggest even 4% may be too high if you want to be certain your portfolio will live longer than you do. One influential paper even suggests 2% might be a more prudent maximum. With that small a withdrawal rate you’d need a massive nest egg to produce a trickle of cash flow, and most people will simply never save enough to make that feasible. So what’s a retiree to do?
The 4% solution.
The origins of the 4% withdrawal rate go back to William Bengen, who was working as a California financial planner in the early 1990s. When clients kept asking him how much they could safely withdraw from their portfolios, Bengen found he had no credible response. So he undertook a study using U.S. data on stock and bond returns since 1926 to find the maximum steady cash flow that could have been withdrawn each year from a balanced portfolio of half large-cap stocks and half government bonds. He assumed the money needed to last 30 years, so people retiring at 65 could be confident their nest eggs would make it to at least age 95.
His research in 1994 found the maximum safe withdrawal rate was about 4% of the initial portfolio, plus annual inflation adjustments. For example, say you have $500,000 in stocks and bonds when you retire. In the first year, you would withdraw 4% of that amount, or $20,000. In the second year, if inflation is 2%, you would raise that amount to $20,400 to maintain your spending power, and so on every year. (Note the withdrawal amount does not change as the portfolio rises or falls in value—all the calculations are based on the value of your nest egg in the first year.)
Bengen determined that if you followed this strategy during any 30-year period between 1926 and 1993, you would have never run out of money. That includes even the worst periods spanning the Great Depression and the double-digit inflation of the 1970s. In later research and a book he wrote for other financial planners, Bengen pushed the safe withdrawal rate to 4.5%. A host of other studies have used updated data, tinkered with the assumptions, or used other statistical techniques to come up with a number a little higher or lower than 4%. That’s the number many financial planners still use.
But does it still work? Wade Pfau, an associate professor of economics at the National Graduate Institute for Policy Studies in Tokyo, came up with a much drearier number in a study last year. Pfau analyzed how interest rates, dividend yields and stock market valuations helped explain maximum withdrawal rates in the past. Then he combined those historical results with recent investment indicators to forecast a maximum withdrawal rate that might apply to people retiring now. His estimate was just under 2%.
That result is shocking and controversial, and even Pfau acknowledges it is far from conclusive. But as he wrote in a recent blog: “I think the real lesson from this exercise is that using a 4% withdrawal rate from a portfolio of risky assets is not as safe as the historical outcomes would lead us to believe.”
Bengen continues to say retirees can still rely on a 4% or 4.5% withdrawal rate, but acknowledges these are challenging times. “The future we’re facing has so many unusual circumstances. We may be heading towards something totally unprecedented. That’s why I raise these doubts and ask people to be cautious.”
The future may be different.
While the 4% drawdown is often called the “safe” withdrawal rate, you need to understand it isn’t bulletproof. No one has a crystal ball, so we can’t be certain future patterns of investment returns and inflation will be similar to those of the past. We can make assumptions based on history and current economic conditions but can’t precisely quantify the risks that lie ahead.
The financial risks you face when retired are different from those of other investors. First, there is longevity risk: the possibility of outliving your money. And you don’t know if your cash flow projections will be enough later in life if you run into expensive health issues.
But the most pernicious pitfall may be what the experts call “sequence of returns” risk. Many investors put faith in stock prices rising over the long run, but older investors are especially vulnerable to market meltdowns in the early years of retirement. If that happens, retirees may be forced to draw living expenses from beaten-down portfolios. Then, if markets stay low for a few years, portfolios may be too depleted to recover when things improve.
Most studies use data from major stock and bond indexes, but this assumes investors actually receive index-like returns—most do not, because of investment fees. Rather than subtracting costs from investment returns in his studies, Bengen lumps them in with other annual living expenses—so if you use a 4% rate to withdraw $30,000 and pay $5,000 to your adviser, you’d have just $25,000 left for everything else. If you deduct fees from your return assumptions, you’re probably still in the ballpark of a 4% withdrawal rate if you use low-cost index funds and follow a disciplined Couch Potato approach. But if you use other strategies with higher fees, you can’t ignore these in your calculations. “It has to be accounted for,” says Bengen. “It’s a big issue in a low-return environment.”
Finding your magic number.
So can you still rely on a maximum withdrawal rate around 4%, or should you go with something lower? It comes down to a judgment call: if you want more safety, you can always cut back to a withdrawal rate of, say, 3% or 3.5%, but we know many people will have a difficult time living on such reduced cash flow. Another approach is to stick with a 4% withdrawal rate and take steps to limit the risks. Here are four strategies to help you do that:
1. Cut withdrawals if you suffer losses. While the 4% safe withdrawal rate is intended to sustain you even in dismal investment periods, it’s still smart to reduce the amount you draw from your portfolio when it suffers setbacks. That way you reduce the risk of outliving your money. Bengen encourages retirees to keep an eye on their “current withdrawal rate,” which is the annual drawdown as a percentage of a portfolio’s value today (as opposed to its initial value at the time of retirement). As a guideline, he suggests cutting back if you exceed the following current withdrawal rates: 5.6% at age 65; 5.9% at age 70; 6.25% at age 75; and 7.5% at age 80. “The idea is to catch the problem before it becomes too big,” says Bengen. By the same logic you can afford to increase your withdrawals if your investments do exceptionally well in the early years, but you build in a bigger margin of safety if you avoid that temptation.
2. Use home equity for backup. You shouldn’t count equity in your home as part of your portfolio when calculating your initial withdrawal rate. However, that equity can provide backup support. Owning your home reduces your accommodation cost compared to renting an equivalent dwelling, so you don’t need to withdraw as much from your nest egg to enjoy the same lifestyle. Later on, it can help if your finances get tight for whatever reason. It may be that your investments underperform and it looks like your portfolio might run dry. Or you may have health problems and need to spend more than you bargained for.
If you stay in your home, you can tap into the equity using a reverse mortgage or secured line of credit. Or you can draw on the proceeds from selling your home to help cover costs of assisted living or a nursing home. Just don’t tap into the equity early in retirement for a frivolous purpose.
3. Add annuities to the mix. Traditionally, the key assets in a retirement portfolio have been stocks and fixed-income sources (bonds and GICs). However, there is growing recognition of the benefits of adding annuities as a third category. Most research into safe withdrawal rates has been based on traditional stock and bond portfolios, but Bengen is a staunch advocate of using annuities if finances start to get tight.
Annuities, which are purchased from insurance companies, provide cash flow for life in exchange for a lump sum. Not only do they ensure you won’t outlive your money but they usually have a higher payout rate than you can expect from a stock and bond portfolio, especially for older seniors. A recent quote for a joint annuity (which continues to pay while either spouse is alive) for an 80-year-old couple had an initial annual payout rate of 7.1%, with the amount growing by 2% a year, and a guaranteed payout period of seven years. Bengen says at age 80 retirees get attractive rates that are hard to beat with a balanced portfolio.
While annuities have advantages late in life, consider starting earlier. Many experts say the “sweet spot” when annuities make the most financial sense starts around 70 these days. But whatever age you start annuitizing, do it gradually so you’re not overly dependent on the payout rate at any particular point in time. The key downside of annuities is that while they last for life they won’t leave anything to your heirs (beyond any guarantee period).
4. Invest conservatively. With stocks and bonds, you have to get the right balance of risk and expected reward. But if you agree investment risks are unusually high these days, it may pay to be more conservative.
Currently Bengen recommends an asset mix much more conservative than the portfolios on which his research is based. He suggests a typical 60-year-old investor consider putting as little as 20% or 25% of a portfolio in stocks, 8% in gold, and the rest (67% to 72%) in fixed income and cash. “I’d rather lose some returns than lose a lot of money for my clients,” he says.
Other experts aren’t as conservative as Bengen. One mainstream approach is to have 50% to 60% of your portfolio in stocks, but favouring relatively stable stocks that pay reliable and growing dividends. That won’t protect you completely from a market meltdown but it should soften the impact compared to stocks that don’t pay any dividends. In the event of a bear market, reliable dividends may continue to meet much of your income needs (though perhaps not all), thereby reducing the need to sell stocks at distressed prices.
In the case of Jim Phillips, the financial planner took the traditional route, advising him to withdraw 3.5% to 4% of his initial capital each year, with annual inflation adjustments. Luckily, this was in line with his middle-class spending needs. He has the extra advantages of a paid-for house and knew he could trim spending if conditions worsened. His wife, Linda, is still working and will get a good pension. All this “gave me the assurance we’re doing okay.” He retired last year and hasn’t looked back. “I feel I’ve made the right decision and I’m on track.”
In the end, like Phillips, you can still expect the 4% withdrawal rate will provide you with a secure retirement with little chance of outliving your money—but it’s always a good idea to hedge your bets.