The number one retiree fear is that they will run out of money in retirement. That is understandable given how severe the consequences could be.
There is a lot riding on making sure your money lasts throughout retirement. If you run out of money, the solution may not be as simple as just going back to work. Even if you are physically able to work, you may not be able to find someone willing to hire you. Years taken out of the workforce may mean that your skills aren’t up to date.
Fortunately, you don’t have to wildly guess whether your money will last throughout retirement. There is research that can provide you with some insight for creating a plan. The plan is key. Planning for withdrawals in retirement is just as important as saving for retirement.
Start by thinking about withdrawing an amount from your investment portfolio each year to cover living expenses.
This basic idea is where most people start to think of retirement income – withdrawals from a portfolio or retirement account.
The natural question then becomes “How much can I withdraw?”
Bill Bengen set out to answer that question in what is now the landmark study of portfolio withdrawals. In his research, Bengen wanted to find what he called the SAFEMAX or safe maximum withdrawal rate. Using historical data from 1926 to 1991 he wanted to know the largest initial withdrawal, in percentage terms, a retiree could take without running out of money.
What he found was that a retiree could take an initial withdrawal of 4% of their portfolio in the first year they retired without running out of money. In all scenarios tested, the retiree never ran out of money with a 4% initial withdrawal rate.
This is where we get the “4% rule” of retirement withdrawals. It is a good basis for retirement income planning, but you shouldn’t just blindly follow it.
Step by Step Process
Some parameters to his study are very important to understand:
- He planned for a 30-year retirement period. This is important to understand because your situation may be different. You may have a much longer or shorter retirement period. You should adjust your initial withdrawal accordingly. If you think you’ll be retired longer, you would need to take a smaller withdrawal. If you think you will have a shorter retirement, you can take a larger withdrawal.
- He assumed a portfolio held a constant asset allocation – throughout retirement. He did not adjust his portfolio to hold more bonds over time. This is very different from the conventional wisdom that you should reduce your stocks as you age. His study also showed that portfolios with stock allocations between 50% and 75% lasted longer. Lower stock positions did not support higher withdrawals.
- The first withdrawal was the only withdrawal based on the 4%. Each subsequent years’ withdrawal was the previous years’ withdrawal adjusted for inflation. As the portfolio value grew or fell based on investment performance, the withdrawal was simply adjusted for inflation.
It is also important to understand that this was the largest initial withdrawal that would not deplete the retiree’s savings in the WORST CASE.
Bengen considered how long the portfolio would last given different withdrawal rates depending on the year retirement started. In other words – if you retired in 1926 and withdrew 4%, how long did the portfolio last? Then, if you retired in 1927 and started with a 4% withdrawal, how long did that last?
He repeated the process and found that the shortest length of time a 4% initial withdrawal lasted was 33 years. In most cases, it actually lasted a full 50 years!
Of course, these results are backward-looking. We can’t know for sure what the future will look like or what the SAFEMAX may be going forward. However, you can incorporate insights from the study to help plan your own retirement income.
About the Author:
Brandon Renfro: I am a fee only financial advisor and Assistant Professor of Finance at East Texas Baptist University. I have been in the Arkansas Army National Guard since 2009 and am an Infantry Captain in the 39th Infantry Brigade.