Back in the 1990s, financial adviser Bill Bengen gave advice that shaped many people’s corporate wellbeing well after they finished work. Bengen said that if you withdraw 4.5% of your retirement savings each year, adjusted for inflation, your money should last 30 years. This became known as the 4% a year rule, but does it still apply in today’s financial crisis? In January this year, US researchers published a thought-proving paper, “The 4 Percent Rule Is Not Safe in a Low-Yield World,” which has changed the way corporate wellness experts have viewed retirement withdrawals – one size does not fit all anymore.
These days, we’re living longer and our investments are earning half of what they might have done 15 years ago. It’s not as simple as sticking a number on it, you need to factor in three things when figuring out how much to withdraw annually from your retirement funds; your time horizon, asset allocation mix and – what’s most often overlooked – the potential ups and downs of investment returns during your retirement. Let’s take a look at each of these factors in a little more detail.
1. Time Horizon: You may live for more than 30 years after you retire, which means your nest egg has to last that long. The younger you start tapping your retirement savings, the lower the annual withdrawal percentage must be for savings to last. Let’s say you retire at 63; you’ll probably need to withdraw no more than 3% each year. If you retire at 70, on the other hand, you may be able to take 7% out of your nest egg on a yearly basis. However, don’t wait any longer than that, as the law requires you to make the minimum distributions from traditional IRAs and employer-sponsored retirement plans at age 70½.
2. Asset Allocation: Your asset allocation mix is basically the amount of your portfolio in stocks and the amount in bonds, and this can have a real impact on how much money is safe for you to withdraw in each year of your retirement. It’s tempting to reduce your risk level as you approach the time in which you’ll need to tap your investments, but putting 100% of your money in bonds probably won’t generate the returns you’ll need to make your money last 30 years or longer. If you have a 100% bond portfolio and withdraw 4% of your nest egg every year, the chance of your money lasting 30 years is just 35%. However, with the same withdrawal rate and a portfolio that’s composed of 75% equities and 25% bonds (using conservative assumptions), having enough money is almost guaranteed. Remember, the higher your percentage of bonds, the lower your annual withdrawal rate should be.
3. Ups and Downs of Investment Returns: Last of all, it’s important to think about the timing of investment returns in retirement. The most vital returns occur in the first two years of retirement, as anyone who retired in late 2007 and suffered big portfolio losses over the next couple of years will tell you. It’s hard to make up for the shrinkage if your retirement savings take a huge hit early on, so it may make sense to put a portion of your savings in a fixed annuity shortly before you retire. This will provide a guaranteed income stream for a set period of time, usually until death, which will help to guard you against potential market downturns. Otherwise, if crisis hits in the first few years of your retirement, you’ll probably need to take out less than 4% if you don’t want to run out of money.