A growing number of retirement researchers believe it's possible to live better in your golden years than the conventional wisdom suggests. They say the popular 4-per-cent rule errs too far on the side of caution.
To understand their case, consider how the rule works in practice. If a person begins retirement with a portfolio worth, say, $500,000, the 4-per-cent rule says she can safely withdraw $20,000 in the first year after she quits work – in other words, 4 per cent of $500,000. (Just to be clear, the withdrawal includes dividends and interest as well as capital – it's a total figure for what she takes out of her portfolio.)
Each subsequent year, she bumps up that starting $20,000 by the amount of inflation to maintain a level amount of purchasing power throughout her retirement.
Even if her portfolio dips below its starting value, she keeps increasing her withdrawals by the amount of inflation, so her take is always equal to an inflation-adjusted 4 per cent of her starting portfolio.
Why 4 per cent? The rule began with a landmark study done by U.S. financial planner William Bengen in 1994. He looked back at several decades of market history to determine what withdrawal rate would have allowed a balanced portfolio of stocks and bonds to soldier through the market's biggest plunges and still have at least a penny of value left at the end of 30 years.
He found that 4 per cent seemed to be the magic number for safe withdrawals. That figure quickly became enshrined, at least in popular wisdom, as the touchstone for good retirement planning.
But it comes with caveats. Most significantly, it's based on the worst cases for investors, such as retiring just as the Great Depression began or immediately before the inflationary storm and market meltdown of 1973-74. As a result, it is a conservative strategy.
Most investors don't encounter a market collapse just as they quit work. Many, in fact, enjoy just the opposite – a strong market that propels their portfolio higher and higher.
Investors who stick to the 4-per-cent rule often wind up with more money after 30 years of retirement than they had when they quit work. Michael Kitces, director of research at Pinnacle Advisory Group in Columbia, Md., has estimated that the median investor who sticks to the 4-per-cent rule will actually increase his or her real wealth by 60 per cent during three decades of retirement.
That raises an obvious question: If the typical investor will do so well with the 4-per-cent rule, why not bump up the withdrawal limit to allow retirees to live a little better?
It's at this point that the debate becomes intensely personal.
Some people put security first and are willing to live modestly in exchange for the added confidence that they will never wind up penniless, no matter how badly the market may fare. If they happen to leave a big bankroll behind, that's fine, because it will go to their heirs.
Other people think the real risk is missing out on retirement travel and the chance to enjoy life after they quit work, because of an unnecessarily tight budget that will leave them at age 90 with a big portfolio but lots of regrets for all the opportunities they passed up.
Maybe, say researchers, the problem is that we're looking at things the wrong way. The essential difficulty with the 4-per-cent rule – or any fixed spending rule, for that matter – is we're trying to create a stable flow of buying power from innately volatile portfolios. Why not assume that we will adjust our spending to reflect the ups and downs of our investments?
Jonathan Guyton, a financial planner with Cornerstone Wealth Advisors in Minneapolis, has published several articles outlining a rule-based strategy that adjusts withdrawals depending on how your portfolio has fared.
He suggests that retirees can safely withdraw more if they are willing to follow several guidelines – for instance, they forgo inflation increases after years in which their portfolios lose money, and they cut their spending by 10 per cent if their withdrawal rate based on the size of their remaining portfolio (not the starting portfolio) rises more than 20 per cent from where it started (to, say, 4.8 per cent from 4 per cent).
On the other hand, he allows retirees to boost their spending by 10 per cent if the current withdrawal rate falls more than 20 per cent from its original level (for example, to 3.2 per cent from 4 per cent).
He calculates that people who follow these rules can raise their initial withdrawal rates to between 4.6 and 5.2 per cent, depending upon the asset mix in their portfolios.
That may not seem like a big deal, but consider that retiree with $500,000. Bumping up the withdrawal rate by a percentage point gives her an extra $5,000 a year of spending power, which can substantially improve her standard of living.
If nothing else, Mr. Guyton's work shows that a bit of flexibility in terms of your retirement planning can pay off, with little sacrifice in terms of safety. That's a lesson we should all welcome.