Adjust the 4% Rule Enough and You Might End up with Something as Good as the Actuarial Approach

Charles Schwab recently released their guidance regarding how much a retiree can spend each year entitled, “Retirement Spending: How Much Can You Afford?”  The authors state, “The 4% rule is a simple rule of thumb, but needs adjustment to fit current market conditions and your situation.”  The adjustments to the 4% Rule recommended by the authors include:

• Adjustments to reflect your investment allocation 
• Adjustments to reflect your selected confidence level of not running out of money 
• Adjustments to reflect your planned time horizon, and 
• Possibly annual adjustments to reflect changes in future conditions

The authors provide a chart of recommended withdrawal rates based on time horizons, allocations and confidence levels. The interesting result of this chart to me is that differences in withdrawal rates resulting from different combinations of asset allocations confidence levels are much smaller than differences resulting from different time horizons.  In fact, I would say that for most combinations of asset allocations and confidence levels, the differences are almost negligible for the same time horizon. 

How different are these withdrawal rates from comparable rates developed using the Actuarial Approach?  Not very.  If we are looking at a retiree with only accumulated savings and a Social Security benefit that is currently payable, the withdrawal rates determined using recommended assumptions under the Actuarial Approach are 4.35% for a 30-year period of retirement, 5.97% for a 20-year period and 10.89% for a 10-year period, or very similar to the rates shown in Schwab’s chart above for confidence levels somewhere between 90% and 75%.

The authors suggest that retirees annually revisit their spending plan, “and increase the amount by inflation each year thereafter—or re-review your spending plan based on the performance of your portfolio.”  So retirees have a choice in the future between increasing last year’s spending by inflation or recalculating a new withdrawal rate based on the chart above (using interpolation methods if necessary).  This is very similar to the Actuarial Approach, where you essentially have the same choice (to use the actuarially calculated withdrawal or a smoothed value).

So, I believe the Schwab approach can probably produce a reasonable spending budget for a certain type of retiree.  That type of retiree:

• Has already set aside separate reserves for long-term care costs (or has sufficient insurance), emergency expenses, and legacy costs 
• Has no other sources of income, such as fixed dollar pensions, annuities, deferred annuities or deferred Social Security benefits.

If a retiree does not fit this criteria, then that retiree will have to make additional adjustments to the Schwab approach to develop a reasonable spending budget.  Of course, rather than making all these adjustments to the 4% Rule, the retiree could simply use the Actuarial Approach.

One final note on the Schwab article.  It strongly implies that since the life expectancy of a 65-year old male or female is currently much less than 30 years, the 30-year retirement horizon used to develop the 4% Rule may not be appropriate for time horizons for many retirees.  I encourage retirees not to use current life expectancy to develop a retirement horizon as 50% of all individuals are expected to live past their life expectancy.  See my last post for guidance on selecting retirement horizons.