Thoughts On Money

Weathering the Withdrawals


Much of the financial planning industry is built around one particular client goal – retirement. According to AARP 10,000 baby boomers are retiring every day, that’s 7 new retirees a minute.  This means there are a lot of retirement conversations happening all day long, all around the world and a whole lot of financial plans are being created to help map out retirement.  Many of these financial plans are created to answer one simple question, “Do I have enough?”

There is a lurking fear for many Americans that they might outlive their savings.  To help combat this concern, many financial advice givers have adopted a “4% rule.”  This is a rule of thumb that identifies a 4% withdrawal from an investment account as a “safe” and sustainable withdrawal rate.  It’s always nice to have this back-of-the-napkin calculation handy, but where did it come from?  Are withdrawal rates really this simple?  Are they a “one size fits all?”  Great questions and a great topic for us to cover here on TOM.

So off we go…

The Man Behind the Rule

William P. Bengen is the man’s name and I doubt you’ve ever heard of him.  I personally heard about the “4% rule” much before ever learning about its founder, Mr. Bengen.  This MIT graduate studied aeronautical engineering during his undergraduate years and would later go on to start a financial planning practice in El Cajon, California.  Bengen published a piece in 1994 in the Journal of Financial Planning titled, Determining Withdrawal Rates Using Historical Data.

Bengen was most interested in identifying what percentage of a balance a retiree could withdraw without ever running out of money.  He had seen many advisors rely on historical averages to determine a withdrawal rate, but he also knew that the markets did not deliver average returns each year. The sequence of these returns would play a big effect on the sustainability of the chosen withdrawal rate.

Time Out, Let’s Discuss This Further

I don’t want to glaze over this part because it is important, and it can be difficult to conceptualize.  To help, let’s look at the last 90 years of return data from the S&P 500 (provided by NYU Stern):

From 1928 to 2017 the average (geometric) return, with dividends included, for the stock market (S&P 500) was 9.65%.  On the chart above I highlighted in green every year the market had a return that was between 8% and 12%, which was ONLY 4 times over 90 years.  Just as Bengen proclaimed, the market didn’t deliver it’s “average” performance very often.

The big problem with the high variation of possible returns is that it makes projecting out a 30-year retirement very difficult – there are an unlimited amount of potential return outcomes.  If you were to retire at the beginning of 1929 you would experience 4 consecutive years of gut-wrenching negative performance, The Great Depression was not a great time to start your retirement.  On the other hand, if you were to call it quits in 1982 you would have had 18 years ahead of you where you would only experience one negative year, 1990 down 3.06% (dividends included).  Granted these hypotheticals are only referencing stock performance and a retiree would most likely have a diversified portfolio made up of stock, bonds, alternatives, and cash.

How Did Bengen Settle On 4%?

After his in-depth study of historical market data, Mr. Bengen concluded that a retiree with a balanced diversified portfolio could withdraw 4% per year and have a very low probability of ever running out of money.  Whether the timing of retirement was perfect or unfortunate, this 4% withdrawal could be sustained throughout a 30-year retirement.

Knowing that Bengen was seeking to solve for something that could withstand a “worst case scenario” outcome, we can conclude that he was really creating a one-size-fits-all rule. A rule that couldn’t really be challenged because it was able to weather any storm (from a historical standpoint). Our founder of the 4% rule would later go on to correct himself in a revised paper stating that 4.5% tax-free is a feasible rate and 4.1% for taxable.

I’m Not Average

Here’s the reality though I’m not average and neither are you.  Although rules of thumb are good for helping provide quick context, they aren’t always the perfect plan.  If you anchor towards something that is built for a worst case scenario and you experience a best case scenario then you are going to have a lot of leftovers.  This is why I am an advocate for a customized withdrawal rate.

This customized withdrawal rate should be built around the context of your particular financial life. Your investment allocations, your tax rates, your expense needs, your goals, your personal inflation rate, etc.  I appreciate the fact that we can be confident that 4% is a good starting point, but I also embrace the idea of recalibrating these withdrawals each year to fit you.

I especially like what Michael Kitces, finance blogger had to say about this particular subject:

Even when starting with a 4% initial withdrawal rate, less than 10% of the time does the retiree ever finish with less than the starting principal. And it has only happened four times in the ‘modern era’ of markets: for retirees who started a 30-year retirement time horizon in 1929, 1937, 1965, and 1966. In essence, then, these are the retirement years upon which the 4% rule is based; the whole reason we use the 4% rule is specifically to survive these kinds of ‘worst-case’ unfavorable-sequence-of-return scenarios we’ve seen historically.

My Takeaways

Today’s topic isn’t the sexiest subject matter, but an important one nonetheless.  Most of us will get to a point someday, if we aren’t already there, where we will want to figure out how to ration out our nest egg over our lifetime.  I’ve seen some folks that constrict their withdrawals so tightly and miss out on enjoying the fruits of their labor as they are always fearful of running out.  Still, others are much too liberal in spending down their retirement savings and I’m fearful for them of what their future may look like.  Somewhere in there, we can find a balance.  A place in which we enjoy spending the income that we prepared for ourselves, generously give to the causes we believe in, and map out how we want our financial legacy to be passed down.  Much of this comes from planning.  Collaborating with a knowledgeable professional that will walk alongside you on this journey of preparing for retirement and living out retirement.  I would encourage you to seek this person out and begin a planning discussion today. 😊


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