Note: This article is part of
Morningstar's October 2014 5 Keys to Retirement Investing special report
(http://www.morningstar.com/goto/5Keys). An earlier version of this
article appeared Jan. 26, 2012.
The so-called
4% rule has been in vogue for almost 20 years now, taking off in
popularity since financial planner William Bengen introduced his
research in 1994. This rule back-tested data to demonstrate that
retirees withdrawing 4% of their portfolios per year for 30 years had a
low probability of running out of money during their lifetimes. Several
years later, the Trinity study, so named because it was authored by
three professors at Trinity University in 1998, looked back at market
data and generally corroborated Bengen's findings. The study concluded
that retirees using a 3% to 4% withdrawal rate, combined with annual
inflation adjustments, had a good chance of not running out of money
during a 30-year period.
Some
critics, notably William Sharpe and a team of researchers from
Stanford, have since assailed the 4% rule as being too simplistic;
others have asserted that Bengen's assumptions about asset allocation
were too aggressive for many retirees. Financial planner Michael Kitces
has argued in favor of a withdrawal rate that's sensitive to market
valuations, an approach that he discusses in this video. More recently,
critics have called the 4% rule too ambitious given the feeble return
expectations for the bond market as foretold by today's tiny yields.
Although
the debate about safe withdrawal rates is alive and well, I'd argue
that the 4% rule isn't an unreasonable starting point for retirees and
soon-to-be retirees attempting to gauge whether their spending is
sustainable. Importantly, the rule is intuitive--you don't have to be a
pocket-protector-wearing owner of a financial calculator to see if your
nest egg and spending rate are close to where they need to be. And, to
the extent that 4% is a fairly conservative withdrawal rate, it helps
shield against the biggest of all risks that retirees face: running out
of money during their lifetimes.
That said, successfully employing the 4% rule requires that you understand the assumptions behind it, including the following.
Where Is the Money Coming From?
When it comes to the 4% rule, "withdrawal rate" is something of a misnomer, because you're not necessarily invading your principal to generate the entire 4%. Instead, the 4% can come from bond and dividend income, capital gains distributed by your mutual funds, or selling securities.
Say,
for example, you're about to retire with a $1.5 million portfolio, 40%
of which is in bonds and the rest in stocks. Using the 4% rule, your
initial withdrawal in year one of retirement would be $60,000. Assuming a
3% income distribution from your $600,000 bond portfolio ($18,000) and a
1.5% dividend yield from your $900,000 in stocks ($13,500), that's
$31,500 in bond and dividend income that you could tap before touching
your principal. The flexibility to draw your money from a variety of
sources--and to not take sides in the income versus total return
debate--is one reason that a "bucket" approach to retirement income can
make sense for so many retirees.
The Role of Asset Allocation
In addition to understanding that the 4% rule doesn't always necessitate selling off assets, investors should also be aware that a 4% withdrawal rate won't automatically be sustainable for each and every asset allocation, particularly ultraconservative stock/bond mixes that generate low real returns. Both Bengen's research and the Trinity study found that portfolios with a mix of both stocks and bonds had the highest probability of long-term sustainability. The reason? Even though retirees may have to tap capital to arrive at their 4% payout, appreciation from the stock component could help offset inflation and periodic invasions of principal, while bonds provide ballast for the equity piece.
Bengen's
original research asserted that an optimal starting allocation when
applying a 4% withdrawal rate was 50% to 75% equity, whereas the Trinity
study authors, in an update to their original study, corroborated that a
starting asset allocation of 50% or more in large-cap stocks helped
retiree portfolios achieve the best probability of not running of money.
Making room for a healthy component of equities looks especially
important right now, given increased longevity as well as the ultralow
yields available from fixed-income securities.
Time Horizon
Like asset allocation, a retiree's time horizon also plays a critical role in the sustainability of a withdrawal rate. Bengen's research looked at the viability of various withdrawal rates and asset allocations over drawdown periods of 30 years, whereas the Trinity study evaluated withdrawal rates over periods of 15, 20, 25, and 30 years. In general, the Trinity study showed that investors with shorter holding periods could employ a higher withdrawal rate than those with longer holding periods. That finding has implications for those who have longevity on their side (they'd want to be more conservative about their withdrawal rates), as well as for those who have reason to believe they have shorter time horizons. (Such individuals could reasonably employ more aggressive withdrawals.)
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