Unpacking the 4% Rule for Retirement-Portfolio Withdrawals

By Christine Benz

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.) 

XIRR/CAGR: Investor's true performance indicator! (4)

Read? XIRR/CAGR: Investor's true performance indicator! (3)

Another good reason why we must fully aware of our average rate of return over market cycles.

Read on. You may understand it better.

Retirement: how much is enough?


Funding your retirement years comfortably is a trade-off between playing it safe, taking risks and spending prudently

By BEN FOK

AT A FAMILY function, my 60-year-old cousin Peter asked me for my views on retirement planning. He said that over the last 35 years he has worked hard, consistently saved and prudently invested his money. When he retires in two years' time, this should provide him with a nest egg of about $500,000. As I listened to him, it seemed that he had secured his financial future. But he kept asking: 'Is it really enough?'

At this age, many would expect to have a significant retirement nest egg. If they don't, they had better do something about it now.

In Singapore, our official statistics show that there are more than 300,000 individuals aged between 50 and 54 who are due to retire in 10 to 15 years' time. As a financial adviser, I often discuss this subject with my clients but often this issue is not treated as a top priority. Understandably, there are other priorities, such as children's education and mortgage repayments or other immediate needs, that take precedence over retirement planning.

Given the current economic volatility, the outlook for those planning their retirement is very cloudy. Over the last two years, we have seen the cost of living here increasing yearly, making retirement more expensive and resulting in many more Singaporeans having to put off retirement for a few more years. With higher longevity and people not saving enough, the working population of those aged 60 and over will inevitably continue to rise.

In Peter's case, he and his wife are healthy and they are likely to have a long life ahead of them. So it would be a mistake to concentrate solely on what's happening now or even on what might happen months from now. Rather, they should focus on coming up with a spending and preservation plan that can assure them of enough money to live comfortably for the next 25-30 years, if not longer.

Hence, funding your retirement years is a trade-off between playing it safe, taking risks and spending prudently.

With the nest egg that Peter has accumulated, he can create a cash flow, and that is the most important consideration during his retirement. At this point, he has to set a reasonable withdrawal rate that will give him the spending cash he needs but won't deplete his nest egg too soon. Peter asked: 'How much can I safely withdraw from my retirement fund every year?' It is obvious that a miscalculation could result in an involuntary return to the workforce or having insufficient funds for retirement.

To help Peter understand how much he can withdraw, I produced a table to show the number of years his money will last.

The table shows withdrawal rates ranging from 4 per cent to 13 per cent and annual growth rate of investment from 3 per cent to 12 per cent, which resembles a 100 per cent stocks to a 100 per cent bonds portfolio.

It also shows how many years a sum will last at various withdrawal rates and various rates of return. If the withdrawal rate and the rate of return are the same, the principal will not change. For example, when $100,000 earns 8 per cent per annum and 8 per cent is drawn, the principal stays the same. This is another strategy by which a retiree can create an income stream. So if Peter invests $500,000 in a diversified investment that can give him 5 per cent returns, he can make $25,000 per year of withdrawals without affecting his principal.

However, if $100,000 earns 4 per cent per annum ($4,000) and 8 per cent ($8,000) is withdrawn annually, the $8,000 annual income will continue for 17 years before the principal is gone.

It is important to understand that the rate of return and the withdrawal rate determine how many years the principal will last. There are no guarantees, of course, but generally the lower your withdrawal rate, the better the chances that your money will last throughout your retirement. But when the earnings are less than the amount that is taken out, you are dipping into your principal, so your money will not last for a long time.

If you start withdrawing a small amount from your portfolio, and adjust it for inflation, the chances are that your money will last longer whether you invest relatively conservatively or aggressively.

So to enjoy a decent retirement, you need to be responsible for your old age by starting to save adequately and invest prudently for your retirement as early as possible. I also believe that it is just as important that people take financial advice well in advance of their anticipated retirement. We have to carefully assess their investment portfolios, as this could make all the difference in the long run.

Singaporeans are intending to retire later, and those planning to stop working between the ages of 60 and 65 will double in the future. With increased longevity comes increased risk of potentially outliving one's retirement assets.

Another point to note is the unexpected 'life events' that may happen. No one can predict what lies ahead in their retirement journey. While we can determine when we want to retire and exercise to keep in good health, there are no certainties in life. Planning for one's retirement years must include taking into consideration life events that have the potential to disrupt your retirement years.

Hence, certain protection products - like medical, hospitalisation and long-term care insurance - are still needed during one's retirement to protect against the potentially devastating effects of unexpected life events like death and chronic illness. We need to have a financial strategy that is flexible enough to adapt to a person's changing needs and circumstances. Retirement can truly be great, but only if you carefully manage your money throughout your golden years.

Note: The strategy described in this article may not be suitable for all readers. If you are in doubt, consult a financial adviser.

Adding A Few More Extra Years Before Executing 3 to 4% Safe Withdrawal Rate

 Spur 14 January 2021 at 13:34:00 GMT+8

Hi Uncle8888,

Hoho, don't think you'll need to decumulate your SA/OA for many years to come!

Unless you're helping your kids to buy properties 😬

Reply

Read? My Sustainable Retirement Income For Life In Singapore - Panda/Koala Retail Investor And CPF Loving Citizen!!!

Read? Relating to SWR

ZERO compounding investment return

In addition to commonly known discussions on SWR and Bucket for FIRE or Retirement; how about transferring all investment income from investment portfolio during FIRE or retirement to Cash Reservoir. This model will more likely to be Safer Withdrawal Rate than Safe Withdrawal Rate by extending a few more years before executing SWR or decumulation of net worth's assets.

Financial Independence : Withdrawal??? Passive Income > Living Expenses???

Financial independence?

How many investment bloggers got it practically right? 

Many of them has failed to recognize this and THIS itself will screw up your withdrawal plan in big way? 

Where is your money for SOME upfront payment?

Read? healthcare insurance

Quote : "At best, if you have private healthcare insurance and intend to make use of the private hospitals or approved clinics, you should view your insurance plan as a reimbursement plan.... you have to pay upfront first and your insurance company hopefully will pay you back ( yes, there will be clauses in your insurance plan to allow them the flexibility of reviewing all charges before paying you back). Payback time is also up to the insurance company."


Why Uncle8888 used Three Taps Solution model as sustainable retirement income for life even he has medical insurance coverage?

Cash is King!

Get it?

Financial independence is passive income > living expenses and safe withdrawal rate e.g. 3% or 4% and investment return beating inflationary rate?

Chun bo?

5 reminders for diligent retirement savers

By David Ning

 

Most personal finance advisors err on the side of encouraging people to stash more money away for retirement, because most people haven't saved enough for retirement yet. But there are certainly a few diligent savers who continue to work even when they have accumulated more than enough to walk away from their jobs. For aspiring retirees who are well on their way to financial freedom, here are a few points to keep in mind.

Saving too much could be just as big of a problem as not saving enough. 

You don't need to spend money just for the sake of decreasing your assets, but it's OK to loosen the purse strings a little if you are already on track to meet your financial goals. Not every expense is worth the money, but there are some ways you can meaningfully spend some of the wealth you've accumulated. Go out with your friends a bit more, reach out to family even if it means traveling and donate to charities that can do good in the world. Spending doesn't just mean getting something new and shiny. There are endless possibilities for how your money can make your life (and those around you) better.

Safe withdrawal rates are based on surviving the worst case scenarios. 

The low interest rate environment has many people questioning the safety of the 4 percent withdrawal rate. As a result, many retirement planners are worried that they have to save even more to achieve a comfortable retirement. But remember that the percentage was derived by studying the markets during two world wars, the Great Depression, the high inflation seventies and every bear market in between. Even if you end up retiring at the worst possible time, you can still significantly improve the odds of your money lasting by being flexible with your spending. Plus, there's also Social Security that will provide the ultimate backstop.

Don't continuously tinker with your portfolio. 

This is an issue I struggle with from time to time. Now that I have a sizable portfolio, it always seems prudent to tweak the portfolio in hopes of earning a higher risk-adjusted return. I've been successful at making my wealth grow a bit faster so far, but I've also spent a considerable amount of time with this part-time job. I have to remind myself of the beauty of simplicity, and when to stop adding complexity to my portfolio. Having more money always seems like a good idea, but what does a higher net worth actually do for me if I'm already on track to retire comfortably? I'm by no means mega wealthy, but why play the game and deal with all the stress when I'm well on my way to winning the retirement savings game?

Avoid looking at the markets endlessly. 

This is another reason why you shouldn't tinker with your investments all the time. Tuning into the noise of the markets will only make you sensitive about every little market movement, making it harder to stay the course. If the emotions of watching wealth go up and down cause you to bail whenever the markets dive, it will be almost impossible to become financially independent. Having an investment plan and sticking to it is one of the keys to success.

Stay motivated to work. 

Don't work so much that you become burnt out and unable to complete your financial plan. Your retirement date is a personal choice, but remember that the timing of your resignation can affect your finances for the rest of your life. 

Don't make any hasty decisions until you've thought it through with a cool head. Quit only if you are truly ready financially and emotionally.

Financial advisors always tell people to save more, but money isn't the only thing you need to live well in retirement. Make sure you can truly reap the rewards of financial freedom. The whole point of being financially independent is so you don't have to trade your time for money. Don't let your stash control you once you've built a nest egg.

-----------

Who is really financially savvy???

Whoever understands them! No?

"When we are in heaven, our money will still be in the bank."

"We don't seem to have enough money to spend; but, when we are gone; there's still lots of money not spent." - Internet


 "We don't live to eat and make money. We eat and make money to be able to enjoy life. That is what life means, and that is what life is for." - Ol' Mallory

What If We Have Slowly Lost Our Risk Appetite After Losing Recurring Income From Full-time Job

Read both blog posts and comments. Digest and understand.  Start thinking!

Rate of investment return, withdrawal rate, and sequence risk affecting future net worth. 

Read? Investing Meant Taking Risks


Read? Sources of income to pay for expenses

I belong to the second category and I have to rely on investments to help me. Ideally, investments should generate sufficient income to pay for your expenses and other spending. This is easier said than done. A lot of time, we have to use our capital to pay for our expenditures (especially during poor investment climate). This reduces our net worth over time.


The next question is where to park our money to achieve investment returns that are sufficient and safe for our investment capital. Well, this is the million-dollar question. One can write a book on investments and there are many books in the market. There are courses on investments that one can take too.


I have reached an age that I cannot afford to take major risk on investments. I have turned conservative and investment returns are moderate commensurate with less risk-taking. As for now, my investment return was about 2.0% in the year that is turning out to be a difficult year. This rate of return is hardly sufficient to cover total expenditures to-date.

3 to 4% Safe Withdrawal Rate For Retirees Across Future Market And Economic Cycles?

 

The Riskiest Day of Your Life

By Larry Swedroe | CBS MoneyWatch

The primary financial goal for most people is to make sure that their assets last as least as long as they do. The day on which there is the greatest risk of failing to meet that objective is the day you retire. The reasons, as "Someday Rich" authors Timothy Noonan and Matt Smith explain, are the day you get your gold watch, you have:

   - Exhausted your human capital (ability to generate income from your labors)
   - Assumed "longevity risk" (the need to fund your living expenses for the rest of your life)

Of the many risks we face when developing a financial plan, longevity risk is often the one most overlooked, or at least underestimated. And yet for many individuals, it might be the one that entails the greatest risk. Consider the following:

Today, while a 65-year-old male has a life expectancy of 19 years (to age 84), a 65-year-old couple has 50 percent chance of one surviving to age 92. That means half of all 65-year-old couples will have one spouse alive after 27 years. And they have a 25 percent chance of one reaching 97. Because being alive without the financial resources to support an acceptable living standard is too painful to even contemplate, we must plan for the possibility that we'll live longer than expected. We can reduce the risk of longevity by working longer, delaying taking Social Security benefits and buying longevity insurance (in the form of a payout annuity).

[Related: 'Does the 4% Rule for Retirement Withdrawals Make Sense?']

The risk of stocks compounds the longevity problem, because contrary to popular belief, stocks are actually more risky the longer your horizon. While returns are less volatile (the standard deviation of returns is less the longer the horizon), the potential dollar results widen as time increases. Remember, even a small difference in returns (let alone a large one) leads to large differences in compound results as the horizon lengthens. And if you thought that stocks were safe if your horizon was long, just consider the case of the unlucky Japanese investors. In 1990, the Nikkei Index stood at close to 40,000. Twenty-two years later, it's close to 9,000. As Keynes might have said, markets can underperform expectations for a lot longer than you can remain solvent. We can address this risk by not taking more equity risk than we have the ability, willingness or need to take, and diversifying the risks we do take as much as possible, avoiding concentrating assets in single (or small groups of) stocks or even asset classes (such as U.S. stocks). Monte Carlo simulation programs can help you determine the appropriate amount of equity risk to take.

Another major issue we face when we retire is moving from the accumulation phase to the decumulation phase. During the accumulation phase, bear markets can be viewed as positive events as we get the chance to buy low as we add assets. When we hit the decumulation phase, bear markets can lead to selling low. And once you sell in order to spend, you can't recover. For example, from 1973 through 1999, the S&P 500 returned 13.9 percent per year and inflation rose 5.2 percent a year. Thus, the real return for an investor in the S&P 500 Index was 8.7 percent. Knowing that in hindsight one would think you could retire in 1972 and safely withdraw an inflation-adjusted 7 percent of your original principal every year and not worry about running out of assets. However, because the S&P 500 Index declined by approximately 40 percent in the 1973-74 bear market, you would have been broke by the end of 1982! In the decumulation phase the order of returns matters a great deal. Once again, a Monte Carlo simulation program can be of great value in helping you determine an acceptable withdrawal rate.

Another risk that increases when we retire from the workforce is inflation, as we no longer have our wages to rely on -- wages which typically increase with inflation. With the increased risk of inflation, retirees should prefer bonds with returns linked to inflation -- TIPS and I bonds -- and avoid long-term nominal bonds. They should also consider an allocation to commodities as they tend to perform well in periods of rising inflation.

There's another risk that increases as we enter retirement: the risk of increasing health care costs. As we lose the health care benefits provided by most employers, we face the combination of longer life expectancies, the majority of medical expenses occurring during the last years of life, and the fact that medical expenses are rising faster than the overall rate of inflation. This leads many to underestimate the risks. Consider the following. The Employee Benefit Research Institute estimates that a 65-year-old couple without employer provided health care benefits could need $216,000 if they live to 80, $444,000 if they live to 90, and $778,000 if they survive to 100. One way to hedge this risk is to purchase long-term health care insurance.

Even a well-thought-out investment plan can be undermined by the failure to consider the aforementioned risks as some are unrelated to investing. This is why it's important to have an investment plan that is integrated into an overall financial plan.

Future Cash Flow For Retirement Life???

Uncle8888 strongly agreed with  Focus less on Net Worth. Think more in terms of Cash Flow


Read? It’s safe to invest entire life savings in stocks. But it can be safer!!! (3)


"When we are in heaven, our money will still be in the bank."

"We don't seem to have enough money to spend; but, when we are gone; there's still lots of money not spent.
 


He is planning in terms of future Cash Flow for his retirement life without leaving lots of money not spent.


The sources of his future cash flow will come from:

1) An investment portfolio generating just 4% yield p.a. at flat rate and non compounding.

2) Yearly partial asset drawn on CPF OA and cash FDs till the last withdrawal on 2036

3) CPF RA, SA and MA as self insured fund for medical and health care and also covered by enhanced medical shield. Assume zero growth.



Using actuarial present value of his future cash flow (excluding the asset value of investment portfolio) and total liabilities @ 2.5% year inflationary rate.

Now, he can reduce his tensions and worries over future market cycles.

First Singapore Savings Bond to be issued on Oct 1: MAS

Uncle8888 is not excited as he already has Singapore's "Savings Bond" since 15 Sep 2011 when he turned 55. No penalty for withdrawal but it will require at least five working days to process the request. LOL!

SINGAPORE: The first Singapore Savings Bond will be issued on Oct 1, 2015 and retail investors will be able to apply for them from Sep 1.

This was announced by the Monetary Authority of Singapore (MAS) on Tuesday (Jul 21) at a press conference on its annual report for financial year 2014/2015.

Singapore Savings Bonds are a special type of Government bonds that cater to individual investors. The Singapore Savings Bonds are aimed at giving individuals a long-term savings option with safe returns. The principal is guaranteed, and they can be redeemed at any time with no penalty.

The interest rates will be linked to long-term Singapore Government Securities (SGS) rates. For the last 10 years, the yield has been between 2 and 3 per cent per annum.

The Savings Bonds will pay an interest rate that increases over time. This means that the longer one holds them, the higher the yield.

Details of the first issue such as the amount of bonds available and the interest rates will be released when applications open. Applications will close on Sep 25.

Successful applicants will receive their Savings Bonds in their Central Depository (CDP) accounts on Oct 1.
Interested investors will be able to apply through ATMs of all participating banks - DBS/POSB, OCBC or UOB - or through internet banking for DBS/POSB.

In order to apply, individuals must have an account with the participating banks, and an individual CDP Securities account with direct credit service enabled.

MAS said a new Singapore Savings Bond will be issued every month for at least the next five years, so there is no need to rush for the first issuance.

For 2015, the Government plans to issue S$2 billion to S$4 billion worth of Savings Bonds.

There is a cap on the amount that investors can hold. They can buy a maximum of S$50,000 for any single issue and hold a maximum of S$100,000 overall. 

The Savings Bonds website is accessible at www.sgs.gov.sg/savingsbonds and members of the public can call the Savings Bonds hotline at 6221 3682 to find out more about the programme.

- CNA/av/ms