Four Percent Rule
Four Percent Rule
October 2010
What is the right amount to withdraw from your retirement nest egg each year?
With stagnant incomes and roller-coaster investment returns over the past decade, many individuals on the brink of retirement or in retirement wonder if standard “rules of thumb” regarding the amount they can realistically withdraw annually from their nest egg—and how to allocate their investments once they walk away from their jobs—still apply.
Chief among the rules of thumb is the “Four Percent Drawdown Rule” first revealed in the 1994 issue of the Financial Planning Association’s Journal of Financial Planning. The landmark article concluded that retirees who took out no more than four percent of a balanced portfolio of stocks and bonds each year could expect their money to last an average of 30 years. That approach has since been gospel in the financial planning industry. However, after a decade that ended with a stagnant stock market and the worst recession in 70 years, some experts are taking a new look at the four percent rule.
Nobel Laureate Professor William Sharpe of the Stanford Graduate School of Business reported recently that this particular rule can be harmful to many retirees simply because of the level of risk tied to stocks and other assumptions, including longer life spans. He suggests that advisors and investors need to do a better job of assessing risk tolerance and consider more stable investment choices along with stocks in portfolios, including hedging strategies and other lower-risk options, as a foundation for post-retirement portfolios that require draw downs for income.
In other words, Professor Sharpe says it is better to focus on clients’ risk tolerance and the construction of a less volatile portfolio, and reconsider a set percentage of drawdown. In fact, Sharpe points out that investors should adhere to a flexible drawdown percentage based on yearly changing portfolio values rather than a fixed withdrawal amount throughout the retirement years. The annual strict “four percent” drawdown concept could lower a retiree’s standard of living unnecessarily, especially in years when the stock market (and retirees’ portfolios) registers losses.
So what are pre- and post-retirement issues you should focus on? Here are key discussions you should have with your financial advisor as well as tax and estate planning experts:
Keep track of your working-life expenses and examine how well your current retirement nest egg and other future income sources could support that spending. This is where your imagined vision of retirement becomes real—or falls apart. A thorough examination of your current spending habits is an important first step in determining how realistic your preparation for retirement has actually been. It will also provide a picture of what else, if anything, has to be done to meet your goals.
After tracking your expenses, set a vision of retirement, then discuss it with your financial advisor just before you retire on how/if it will be funded. Revisit this every year after you retire. If you have already been working with a good advisor, you might have already done this. Nevertheless, realistic retirement goals can change, so treat the subject as dynamic, not static. Talk about your retirement dreams, and work with your advisor on a retirement income strategy based on Social Security benefits, pensions, investment income, and other income sources. A good retirement plan will evaluate if your lifestyle expectations can be funded from these income sources. Review and revise your retirement plan with your financial advisor as necessary, especially during the retirement years.
Make sure your investment asset allocation fits your risk tolerance and aligns best with your goals. Your investment portfolio should include alternative investments, such as funds that hedge downside risk. In retirement, have about one year’s worth of expenses in safe, liquid investments to drawdown from in the event of a significant market decline, such as in 2008. This is so you will not have to drawdown from your investment portfolio in significant down years, which will deplete your nest egg sooner. In other words, be flexible, minimize portfolio risk, and have a cash reserve to increase your chances of a successful retirement.
Build a phased-in retirement. Consider alternatives to a standard “retirement.” This is especially important if your retirement nest egg has declined considerably in the past few years. Many companies are becoming more open-minded about keeping older workers on the payroll part time or hiring workers over age 60 on a contract basis. Keep apprised of such opportunities and the skills it will take to take advantage of them. A successful phased-in or post-retirement work plan will require more than sensible financial planning. It may also require training and other personal investments, such as cultivating good industry network contacts.
Consider worst-case scenarios. For many retirees, increasing healthcare expenses and the cost of end-of-life-care account for significant unforeseen spending. As a result, many retirees pay for expensive experimental treatments or long term care. Current statistics from AARP show that the average private nursing home room costs $78,000 a year. While public aid typically picks up medical expenses for those who exhaust their assets, most of us desire more than minimal standards of care and wish to pass on wealth to heirs or charities. Recent healthcare reform is not close to solving this problem, so it is time to consider various insurance plans that cover (or at least partially cover) these very expensive events.
Bottom line: Work with your financial advisor and other professionals to ensure a successful retirement, and be prepared to make adjustments along the way. Now, more than ever, investors need to pay attention to their nest egg and utilize strategies to minimize risk while providing an income stream in retirement that is flexible based on annual fluctuations in investment value. As such, the days of the standard “four percent rule” no longer apply.
Dean L. Boebinger, CFP®
Strategic Financial Concepts, LLC
Director of Tactical Investment Strategies
20333 State Hwy. 249, Ste. 200
Houston, TX 77070
281.378.8008
