Sunday, January 23, 2011

The 4% Rule for Retirement

How Much Money Should You Withdraw From Your Retirement Funds?

When you retire, presumably in your 60's, you may have Social Security to rely on (hopefully) and your savings.  Perhaps a lucky few will have a defined pension - but those folks are few and far between.

But the question remains, for most retirees, how much money should you withdraw from your retirement account, without running it dry too fast?

Traditionally, most financial advisers have relied upon the 4% rule - withdraw no more than 4% of the initial balance of your account every year:

The way the 4% rule works is that you start by taking 4% out of your portfolio in the first year – this includes dividends, interest, withdrawals. The next year you take out the same figure you took out the first year plus inflation. So if you start by taking $40,000 out and then inflation is 3% then the second year you take out $40,000 + 3% ($1200) = $41,200. Every year after that you adjust the previous year’s withdrawal amount by the inflation rate.

Some folks have criticized this rule as too outmoded or inflexible.   Specifically, some believe that such a plan could end up with a retiree spending too much money too quickly, and end up broke in their waning years.

Frankly, this is a tough nut to crack, as predicting how much you should spend is tough.

Ideally, you should spend your last penny as you take your last breath (screw heirs!) and thus optimize the enjoyment of your income and investments.  But since we can't predict with certainty our life expectancy, this makes the equation impossible to solve, as the one variable (life expectancy) is undefined.

One way around this might be a life annuity, which is why these investment vehicles are becoming popular among people without defined-pension benefits.  But as an investment vehicle, annuities do have some pitfalls as well.  Putting all your money into an annuity, life or otherwise, is probably not a good idea.

Note also, when we talk about the 4% rule, we are not referring to the mandatory minimum withdrawal required for 401(k) and IRA plans.  In order to insure that some taxes are paid on these plans, you do have to withdraw a certain amount every year, once you retire. However, there is no requirement that you spend this money, of course.

And of course, if you have enough money socked away in retirement funds, it is possible this will never be an issue - you can live off the interest or earnings, if you have enough cash, and never touch your principle.  Your heirs will love you for it as well.

On the other hand, if you end up going into assisted living later on in life, most of that money will be sucked up by those expenses.  Many folks play games in this regard, trying to foist off assets to children and other relatives, so as to appear "poor" and thus qualify for Medicaid, to pay for nursing home care.  And in a way, it is one of those middle-class cheating games that many Americans play - people who can "afford" the cost of care, but would rather get someone else to pay for it, so they can leave some dynastic wealth to their children.  And of course, the children, recipients of such largess, will complain about their increased taxes used to pay for all those "other people" on Medicaid.

But getting back to personal finances, how much should you take out every year, and moreover, how much will you need to retire in the first place?

If we assume that a retirement portfolio contains $500,000 in investments, balanced between stocks, bonds, and CDs, etc. in a manner than balances risk and security based on age, let's assume a rate of return starting perhaps at 10% per year at age 65 and then declining by 0.5% every year, as investments are rebalanced away from income and risk and toward security.

Further, let's assume the rate of inflation remains relatively flat (let's hope) at 2% per year.  If we take out 4% initially, that will be $20,000 the first year.  With a 10% rate of return, the account actually increases in value to $530,000 the next year.  But the next year, we withdraw $20,400 to account for inflation.  If we go down the line, the results look something like this:

Year      Balance     Withdrawn     Return     Earnings   
01       500,000          20,000             10%       50,000
02       530,000          20,400             9.5%      50,350      
03       559,950          20,808             9.0%      47,596
04       586,738          21,224             8.5%      49,873
05       615,387          21,648             8.0%      49,231
06       642,970          22,081             7.5%      48,223                 
07       669,112          22,522             7.0%      46,838
08       693,428          22,972             6.5%      45,073
09       715,070          23,431             6.0%       42,904
10       734,543          23,900             5.5%       36,727
11       747,370          24,378             5.0%       37,369
12       760,361          25,353             4.5%        32,416
13       769,224          25,860             3.5%        26,923
14        770,287         26,377             3.0%        23,109
15       767,019          26,904             2.5%        19,175
16       759,290          27,443             2.0%        15,186
17        746,485         27,992             1.5%        11,197
18        729,690         28,552             1.0%          7,297
19        708,435         29,122             0.5%          3,542
20        682,855         29,705             0.0%                 0

The balance on the account will continue to rise until the amount earned is less than the amount withdrawn, at which point, the account will slowly decrease in value every year, until it reaches zero.
This could take 25 years or more, depending on the assumptions you make about inflation and rate of return on investment.  At zero inflation and zero rate of return, the 4% rule will drain an account in 25 years.  In the scenario above, it could take far longer.

It is an interesting equation, and I would enjoy plotting out several scenarios graphically, if I had the time to do so.

Of course, returns on investment will never drop entirely to zero, as in the example.  A retiree can always afford to put some investments into more volatile and higher-return investments.  And even "safe" investments like government bonds, will pay a  yield of a few percent.  The 0.25% savings accounts of today are a strange anomaly, not a new norm.

If you can withdraw 4% from your account and get a 5% rate of return on the balance, in theory, you could never run out of money.  But of course, the amount you withdraw may be based more on your lifestyle "needs" and less on what you have available or what would be prudent.

And one problem many Seniors had during the recent meltdown was that they were overly invested in high-yield, high-risk stocks.  They were enjoying 10-20% rates of return for several years (and withdrawing nearly as much) and now are finding their principle was cut back severely.  As I noted  before, some panicked and sold - putting it all into lower yield investments too late, thus locking in their losses.  Others "doubled down" and went for higher yield, higher risk investments, which was an equally disastrous idea.  A better approach, I think, is to have a diversified portfolio, with the investments gravitating toward "safe" harbors as you get older.  One way to accomplish this is to use money that you are forced to withdraw from your IRA and put it into bonds or money market funds, so as you get older, more and more of your money will be safe from an economic meltdown.

Of course, this is all based on a number of assumptions that might not pan out.  Given those numbers, it appears that the amount withdrawn will not exceed the income earned for many, many years.  But all you have to do is play with rate of inflation and the rate of return, and you could end up draining a retirement account dry in less than a decade.

For example, if inflation rises to double-digit levels again, many retirees might end up broke, long before they die.  An unlikely scenario?  The Fed is trying to crank inflation right now, to stimulate the economy.  The problem is, they are likely to over-crank this, and due to the thermostat (hysteresis) effect,  overshoot their inflation goals, much as we did in the 1970's and early 1980's.

And the problem is - the rate of inflation and the rate of return are not variables entirely within your control.  So in essence, you are trying to solve an equation with three unknowns - your life expectancy, the rate of inflation, and the rate of return on your investments.

In short, it is an equation you cannot solve with any accuracy.  No wonder some folks like the assurance of a life annuity!

But the annuity companies do have to solve this equation in order to price your annuity.  How do they do it?  Well Actuarial Tables are a first step - they can average the experiences of a number of customers together and know, on average, how long most of them will live, and also understand the bell-curve distribution of how many will live beyond that age, or die beforehand.

They also are more likely to take greater risks in investment than you and me, as they can afford to lose more than we, as individuals, can.  As for inflation, they can factor this in, of course, but it is an area where they are risk-taking.  If they guess right, they make a lot of money.  If they guess wrong, they make less.  If they really screw up, they go bankrupt, and you have to hope your annuity is insured by the State.

And the problem is, people are living longer and longer these days - and retiring earlier.  You may end up forced into retirement in your 50's and live well into your 80's.  This could mean a retirement of 30-40 years or more.  If your savings are structured for 25 years, you may run the well dry at the time in your life you need money the most.

I am not sure there is an easy answer to all of this - which is why I am trying to figure this out now, at age 50, rather than waiting until 65 and then saying "Gee, how much money do I have and do I have enough to retire?"

The only conclusions I can draw are this:

1.  Structure your life so you can live on very little money:  Avoid financial commitments like expensive houses, cars, boats, and the like with high tax, storage, maintenance, and repair bills.  Retirement is no time be squandering $10,000 a year on motorized vehicles.

2.  Live on the Interest:  If you can live on the interest of your investments and not touch the principle, the better off you will be, as at least in theory, you could survive forever on that income (unless conditions change, which they will).

3. Work Part-Time:  If your lifestyle is simplified, a part-time job may be all you need to support yourself in later life, which can allow you to delay tapping into those retirement funds for as long as possible.

I wish I had a better answer.  When I was younger, I thought the 401(k) and IRA were a great concept.  Now that I am nearing retirement age, the defined pension benefits seem like a swell deal.

Of course, few people get these nowadays, and in some cases (such as in Illinois) the cost of pensions for government workers are sinking the State budget, as it turns out the State never set aside the money for those pensions.  And I suspect, we will see a lot of private pension funds collapse in the next few decades, as more and more people retire, and it turns out the funds were not properly administered.

So maybe an IRA ain't so bad after all....