Wednesday, November 26, 2014

Don't Use the 4% Withdrawal Rule--And For Gosh Sake, Don't Use it With a Reset Button

In his November 26 article, "Why Retirees Now Have to Question the 4% Withdrawal Rule," Jeff Brown suggests modifying the 4% Rule to make it more flexible rather than maintaining its "set-and-forget" characteristic and employing a lower safe withdrawal rate as some advisers have suggested in light of current low yields on fixed income investments.  Mr. Brown says,

"So how do you get from here to the living-large lifestyle [The 4% withdrawal at initial retirement increased by inflation] described above? With flexibility. You don't need to skimp every year to prepare for a disaster that might never happen so long as you can cut spending if it does.  That way, if the $1 million portfolio [at initial retirement] were to fall to $700,000, you could hit reset and withdraw only 4 percent of the new amount -- $28,000 instead of $40,000 plus inflation. If the fund were to recover, you could hit reset again and take 4 percent of the new amount, then go back to annual increases to offset inflation."

There is nothing magical about 4%.  It happens to be a reasonable withdrawal rate if you are a currently age 65 planning for a thirty-year retirement, you are using the assumptions we recommend for the spreadsheet tools on this website and you have no other annuity income or plans to leave money to heirs.  If you go to the runout page of the Excluding Social Security V 2.0 spreadsheet on this site, you will see that the budget withdrawal from savings under the circumstances described above is 4.34% at age 65, 4.99% at age 70, 5.97% at age 75, 7.60% at age 80 and 10.89% at age 85.  This is just mathematics based on a declining expected payout period as one ages.  Thus, any approach that hits the 4% restart button at an age after 65, is going to miss the mark.

If you are going to utilize a flexible approach that increases or decreases spending budget amounts based on actual experience (be it from investment experience more or less than assumed or spending variations), you are better off using the Actuarial Approach and hitting the reset button on that approach each year to stay on track.  If you want to have some smoothing in your spending budget from year to year, use the smoothing approach we recommend.

Its coming up to the end of the year.  This year again, we will revisit some of the example people we have looked at over the past couple of years to determine 2015 spending budgets for them in light of 2014 experience.  Once again, we will illustrate how effective and how easy the Actuarial Approach budgeting process can be.