Go to the Globe and Mail homepage

Jump to main navigationJump to main content

Retirement (unknown)
Retirement (unknown)

Investor Clinic

How not to outlive your money Add to ...

You've worked hard and saved all your life. You've built up a sizable nest egg. Now it's time to retire.

But before you splurge on a new set of golf clubs and book that lavish Mediterranean cruise, ask yourself a critical question: How much of your savings can you safely spend every year without running out of money before you die? No idea? Read on.

More Related to this Story

THE 4-PER-CENT RULE A popular rule of thumb is that, to make sure your assets don't expire before you do, you should withdraw a maximum of 4 per cent of your savings annually. This guideline is based on historical market returns for a diversified portfolio split 50-50 between stocks and bonds. To maintain spending power, the withdrawal amount is adjusted annually for inflation. For example, someone with a portfolio of $1-million could withdraw and spend $40,000 in the first year (over and above any pension or other money received). Assuming a 3-per-cent inflation rate, the withdrawal in the second year would be $41,200, and so on.

Studies have shown that this approach will provide a stream of inflation-adjusted income that is sustainable for about 30 years - which should be long enough for most people who retire at 65. At least that's the theory.

ONE SIZE DOES NOT FIT ALL The problem with the 4-per-cent rule is that it treats every investor as if they're the same, when people's circumstances - and market conditions - vary considerably. Anyone who retired right before markets fell off a cliff last year can attest to that. "Obviously, the rate of withdrawal ultimately comes down to comfort levels and factors such as time horizon, market returns and inflation, all of which are impossible to predict with accuracy," says Colleen Jaconetti, certified financial planner and co-author of a study on retirement withdrawals for U.S. fund company Vanguard Group.

PLAYING THE PROBABILITIES Using historical returns for stocks and bonds from 1926 to 2008, Ms. Jaconetti and fellow financial planner Maria Bruno studied what withdrawal rates would be appropriate under different scenarios.

They examined three types of portfolios: "conservative" (20 per cent stocks, 80 per cent bonds), "moderate" (50 per cent stocks, 50 per cent bonds) and "aggressive" (80 per cent stocks, 20 per cent bonds).

They also studied seven "planning horizons" ranging from 10 to 40 years. Someone who retires at 55 and expects to live until 95, for example, would have a 40-year horizon, whereas a person who retires at 70 and expects to live to 80 would have a 10-year horizon.

Generally, longer horizons require more conservative withdrawal rates to make the money last, whereas shorter horizons can support larger withdrawals. Finally, the researchers looked at two "success rates" - 85 per cent and 75 per cent. This is the probability, given the portfolio allocation, time horizon and withdrawal rate, that the investor's money would not run out prematurely.

WHAT THEY FOUND The tables summarize their findings. For example, someone with a conservative portfolio and a 35-year horizon who wants to be 85-per-cent certain that they won't run out of money should withdraw a maximum of 3.5 per cent annually.

On the other hand, an investor with an aggressive portfolio and a 10-year horizon who is content with a 75-per-cent probability of success can withdraw 11 per cent of his or her savings each year.

Remember, these are not guarantees: There is a 15-per-cent chance of failure in the first scenario, and a 25-per-cent chance in the second.

A DIFFERENT APPROACH U.S. investing author William Bernstein has also tackled the safe withdrawal question, with slightly different results.

Using the "Gordon Formula", which relies on current dividend yields and historical dividend growth rates to predict long-term equity returns, he calculates that a balanced portfolio of stocks and bonds will generate roughly a 2-per-cent real - or after-inflation - annualized return.

Using that assumption, and allowing for a certain amount of variability in the expected returns, he came to the following conclusions: "For the person who wants to retire at 60 or 65 ... at [an annual withdrawal rate of]2 per cent you're as bulletproof as you're going to get. At 3 per cent you're probably safe. At 4 per cent you're probably starting to take chances," says Mr. Bernstein, whose most recent book is The Investor's Manifesto: Preparing for Prosperity, Armageddon and Everything in Between.

The probability of running out of money with a 4-per-cent withdrawal rate - indexed for inflation each year, as in the previous study - is roughly 20 per cent, he says. At a withdrawal rate of 5 per cent, the risk of outliving your money if you retire at 65 rises to between 30 per cent and 50 per cent, he says.

How the markets behave is, of course, a big factor.

"It's all a probabilistic exercise. There are some periods of time when you could probably get away with [withdrawing]6 or 7 per cent, and there are other times when if you spent 4 per cent and if you lived too long you're going to be eating Alpo in your old age," he says.

There are a few ways to minimize the risk of outliving your savings. You could spend less, retire later or buy an annuity that makes guaranteed payments. Mr. Bernstein prefers what may be the safest option of all: "I'm planning to work as long as I can, and save as much as I can, until I die."

********

How much can you spend safely?

Historical portfolio withdrawal rates in per cent, which resulted

in a 75-per-cent success rate.

Planning horizon

Portfolio

10 yrs

15 yrs

20 yrs

25 yrs

30 yrs

35 yrs

40 yrs

Conservative

10.50

7.25

5.75

4.50

4.00

3.75

3.50

Moderate

11.50

8.50

6.75

6.00

5.25

5.00

4.75

Aggressive

11.00

8.00

6.75

6.00

5.50

5.25

5.00

Historical portfolio withdrawal rates in per cent, which resulted

in a 85-per-cent success rate.

Planning horizon

Portfolio

10 yrs

15 yrs

20 yrs

25 yrs

30 yrs

35 yrs

40 yrs

Conservative

10.00

6.75

5.25

4.25

3.75

3.50

3.25

Moderate

10.50

7.25

6.00

5.25

4.75

4.50

4.25

Aggressive

10.00

7.00

6.00

5.25

4.75

4.75

4.50

Source: Vanguard

Follow on Twitter: @johnheinzl

In the know

Most popular video »

Highlights

More from The Globe and Mail

Most Popular Stories