Can I Retire Yet? (Part II)

Welcome back to the Retirement Hangout! If you haven’t read Part I of Can I Retire Yet?, I recommend that you go back and read that first.

In Part I, you estimated the annual income stream you will need in retirement, and what portion of that needs to come from savings. But what size retirement savings stash will provide that income – for the rest of your life?

Drawing Income from a Nest Egg — the 4% Rule

Perhaps you’ve heard of the 4% Rule. This is the amount many financial planners suggest you can withdraw from a retirement portfolio and be confident your savings won’t run out. If you’re like me, your first reactions to this advice might be dismay and skepticism. 4% is a small number, and it implies you need to save a really big amount – 25 times your annual spending need (for example, you would need $2.5 million to withdraw and spend $100k annually). This might strike you as an absurdly large number and an impossible savings task. You might even be tempted to return to your Internet research in search of a more congenial answer. But wait – recall that your savings only need to cover your spending needs after Social Security and any other income sources you might have coming. Taking this into account, Fidelity and T. Rowe Price estimate that most people should try to accumulate 10 to 12 times their salary by retirement – a daunting amount, but perhaps not so ridiculously out of reach.

Still, 4% sounds arbitrary. What is it based on? It comes from a very clever piece of historical analysis by a financial planner named William Bengen, who invented an area of financial planning analysis known as Safe Withdrawal Rates (SWR). In his 1994 article, “Determining Withdrawal Rates Using Historical Data,” Bengen looked at how diversified stock and bond portfolios would perform over 30-year periods between 1926 and 1994 at different withdrawal rates. He found that a 50% stock/50% bond portfolio would have supported a 4% withdrawal rate, increased by the amount of inflation each year, for 30 years in every period during that time. A 75/25 portfolio performed just about as well; interestingly, 100% stocks was riskier and failed in some instances, as did portfolios with 25% and 0% stocks. The lower-stock portfolios provide an illusion of safety; they avoided sharp losses, but just didn’t grow enough to last 30 years.

Bengen’s analysis has been updated several times, including in the Trinity Study in 1998 and in articles by retirement researcher Wade Pfau in 2012 and 2018 (see references below). In each case, the safety of the 4% withdrawal rate has held up when incorporating more recent data on stock and bond returns — so we know a 4% withdrawal strategy would have worked any time over the last 92 years. In fact, in most periods, a 4% withdrawal rate results in a substantial ending portfolio. This is a good thing – dying with a comfortable amount of money in the bank is far superior to wondering anxiously whether you or your bank account is going to give up the ghost first.

4% Critics — and Defenders

But, you may ask, just because the 4% withdrawal rule would have worked over the last century, how do we know it will work in the future? There are, of course, no guarantees. Critics argue that it might be unwise to rely on the 4% rule going forward. Respected financial planners (including Wade Pfau, cited above) believe that 3 or 3.5% might be a safer withdrawal rate today. Some of these critics point to the low but rising interest rates in the bond market, as well as the high stock valuations in our aging bull market, to make the case that returns, over the next five or ten years at least, are likely to be anemic for both stocks and bonds. Other 4% skeptics, taking a grander historical view of the fate of nations and empires, point out that Bengen’s analysis focused on stock and bond returns in the United States during the ‘American Century,’ when the US economy outperformed all others. There is no natural law that assures that returns in the 21^st Century will be as good as those in the 20th.

Bengen and others, on the other hand, believe in the continued validity of the 4% rule. (See, for example, Michael Kitces 8/15/2012 article, “What Returns Are Safe Withdrawal Rates REALLY Based Upon.”) The near century-long period from 1926 to the present included some tough times – two World Wars, the Great Depression and the Great Recession, and periods of both deflation and significant inflation. Despite this stormy weather, US stocks returned about 10% per year (7% after inflation), while bonds returned 5.5% (2.5% after inflation) (Ibbotson SBBI, 2018). The 4% withdrawal rule is based upon the worst 30-year return for a 50/50 portfolio during this period, about 4.5% after inflation. (This rate of return would have applied to those unlucky enough to retire in the late 1960s, who actually would have done worse than someone retiring in 1928.) Assuming that future returns will be lower than the worst returns from the last 90-odd years seems unnecessarily pessimistic.

While the debate is healthy, the bottom line (in my opinion, at least) is that the 4% withdrawal rule remains a sound and adequately conservative strategy for someone retiring in his or her 60s and looking forward to 30 years or so of retirement. If you are retiring young, and need your savings to last 40 or 50 years, then it would be wise to use a lower number, perhaps 3%. But you get to decide (as a pirate might say, the rule is really more of a guideline). Feel free to follow up by reading some of the articles I’ve cited or do your own research.

Finally — Calculate How Much You Need to Retire

Having stayed with me through this digression on the history and analysis behind the 4% rule, you are now ready to complete your calculation of needed retirement savings. Take the annual amount you expect to need after social security and any pensions, and multiply by 25 (or 33 if you prefer to use the ‘3% rule!’). That amount is the savings you need!

Example – continued from Part I

Your household’s expected annual retirement spending: $100,000

Total expected SS benefits and pension income: $60,000

Unmet need after accounting for income: $40,000

Retirement savings needed (unmet need X 25): $1,000,000

Now – compare the estimated savings need you’ve just calculated with what you actually have saved (or expect to save) for retirement. (Remember to account for any lump sum windfalls or expenses, such as downsizing profits or college expenses, that you are confident will come your way.) How close are you?

What do you do if you crunch these numbers and they don’t quite add up the way you’d like? Don’t despair, you still have options. If you’re not yet retired, you can try to step up your saving or delay retirement by a few years, which can make a lot of difference. In retirement, you might consider a part-time job, or reduce your living expenses by down-sizing, moving to a cheaper area or cutting back on discretionary expenses like travel. In the example above, if the couple could reduce their spending to $80,000 per year, they could cut their needed retirement savings to $500,000. Just be careful not to make unrealistic assumptions to make the numbers add up. Relocating to that coffee plantation in the Costa Rican cloud forest just might involve some difficulties you haven’t thought of!

Congratulations — you’ve just completed retirement planning 101! Go through these simple calculations and you’ll have a sound retirement savings goal to shoot for. If you’re in retirement already, you’ll understand where you stand financially — and hopefully feel confident about pursuing your retirement dreams without money worries. If you identified a savings gap, consider how you might trim your sails and get your ship back on course.