The problem is figuring out how much you can withdraw each year — a tricky calculation at best, since you know neither what you’ll earn in any given year, nor what the rate of inflation will be, nor how long you’ll live.
Financial planners use 4 per cent of your savings as a rule of thumb, which you then adjust each year for inflation. Recently, some have suggested that 3 per cent is more reasonable. But being too conservative will rob you of retirement joy. You can probably take out more than 4 per cent a year and be reasonably assured of not running out of money.
Several academic studies have shown that if you start with a 4 per cent initial withdrawal and adjust it each year for inflation, you have a good chance of never running out of money. The rule of thumb assumes a relatively conservative portfolio, typically 50 per cent or 60 per cent stocks, with the balance in cash or bonds.
Given a $250,000 retirement portfolio, your withdrawal in the first year would be $10,000, or a monthly amount of $833 a month. The next year, you’d boost your withdrawal by the rate of inflation, and so on. Had you followed this plan in 1960 using a balanced fund, which is typically a mix of 60 per cent stocks and 40 per cent bonds, you would not have run out of money until 2002, 41 years later. And this in a period that featured soaring inflation.
Given the low returns from bonds, some academics have suggested lowering the initial withdrawal rate to 3 per cent. There are two problems with that.
The first is that rates probably won’t stay this low forever.
The second is that a 3 per cent withdrawal rate is pretty tough to live off, unless you have a great deal of money, and most people don’t. If you have $250,000 saved for retirement, your initial withdrawal would be $7,500, or $625 a month. Depending on your circumstances — how much you pay for rent or mortgage and your pension benefits and the taxes on your withdrawals—a 3 per cent withdrawal rate could mean a pretty tight budget.
And, says Michael Finke, professor of retirement planning and living at Texas Tech, you could be living a lean retirement for no reason, even if you stick with an initial 4 per cent withdrawal rate. “The 4 per cent rule assumes you’re going to live to age 95, and most of us are going to be dead by then,” he says. “If you’re really conservative, you didn’t run out of money, but you left a lot of retirement joy in the bank.”
Among couples age 65, just 18 per cent will have one person who hits 95.
The other flaw with the 4 per cent or 3 per cent rule: It assumes that each year, you withdraw according to the formula, and increase your budget for inflation. Most people, if they’re having a rough couple of years, will tighten spending or not take the inflation increase, Finke says.
What’s a retiree to do? Finke has two suggestions. If you’re concerned about outliving your money, try to put some of your retirement kitty into a fixed annuity, which guarantees lifetime income. You’ll still be vulnerable to inflation, but you’ll at least know that you’ll get a certain level of income every year. Currently, a $75,000 immediate annuity will get a 65-year-old man about $430 a month, according to immediateannuities.com.
The drawback: If you’re struck by lightning the day after you buy the annuity, the insurance company keeps your money, and you’ll have nothing to spend in your coffin. You can buy annuities that protect your spouse or leave money to your heirs, but they will reduce your monthly payout.
The 4 per cent rule is a decent starting point for retirement planning. But it’s a highly conservative one. If you take up cobra farming in retirement, you can certainly take more. And if you’re willing to cut your budget in the market’s lean years, you can probably start with more than 4 per cent too.