Spending Safely

Advisers now concede that fluctuating conditions make rigid formulas for drawing down savings unrealistic
Alison Seiffer

If you're getting ready to retire, you may already be familiar with "the 4% solution."

For more than a decade, financial advisers have warned retirees that draining over 4% of their nest eggs in their inaugural retirement year could ultimately lead to financial ruin.

The 4% mantra started with Bill Bengen, 60, a soft- spoken investment adviser in El Cajon, Calif., who has written a series of landmark research papers since 1994 on safe withdrawal rates. What most people don't realize, though, is that Bengen no longer recommends the 4% rate. "The figure is stuck in the corner of people's minds, and I don't know how to get it out," he laments.

Bengen now suggests that the 4% figure—actually 4.1% for a 60/40 portfolio of large caps and bonds and 4.5% if you toss in small caps—merely seems impressive when plugged into Excel (MSFT) spreadsheets. In practice, the strategy, which Bengen stopped using with his own clients about three years ago, is inflexible and unrealistic he says—and the formula is too stingy.

Bengen and other financial wonks now advocate less rigid approaches to the tricky challenge of sustaining a nest egg. "We know a lot more about [safe withdrawal rates] than we did 15 years ago," says Jonathan Guyton, a principal at Cornerstone Wealth Advisors in Edina, Minn., who has written extensively on withdrawal issues. "What we are seeing in a relatively short period of time is quite an evolution."

The 4% approach initially seemed to make sense. Under the plan, a retiree with a $1 million portfolio withdraws $40,000 (4%) in the first year. In subsequent years she withdraws the previous year's amount, adjusted by the rate of inflation. So 12 months later, if inflation is 3%, she could pull out $41,200 ($40,000 x .03). If retirees followed this rule, advisers liked to say, there should be almost no chance of a portfolio being depleted within 30 years.

One expert now questioning this conventional wisdom is Michael Kitces, 30, director of financial planning for Pinnacle Advisory Group in Columbia, Md. Kitces was frustrated that the 4% rule can result in overly conservative withdrawal rates during certain market conditions and that the market's mood at the time of the initial withdrawal could greatly affect how much money retirees can drain from their accounts for the rest of their lives.

Kitces looked at two hypothetical couples nearing retirement with $1million portfolios. Couple No. 1 retires and withdraws 4.5% of their assets ($45,000). During the next year, stocks plunge by 15%. Despite the market implosion, couple No. 1 gets to increase their next withdrawal by the inflation rate—in this example, 3%. So in the second year they pull out $46,350.

That all seems fine, Kitces says, until you examine the fate of couple No. 2. They retire one year later than Couple No. 1, but their portfolio drops with the market and is now worth $850,000. Using the same 4.5% withdrawal rate, they are limited to a $38,250 withdrawal, which is 21% lower than the other couple's. "How can we account for a safe spending approach that produces such disparities, given identical circumstances, where the only thing that changes is the timing of the withdrawal starting point?" he asks.

Would it be possible, he wondered, to predict the market environments in which it would be prudent to boost the initial withdrawal rate? After studying historical data, Kitces concluded that a higher withdrawal rate is safe in most situations as long as adjustments are made if the stock market becomes overvalued during the first 15 years of a person's retirement. He judges the stock market's valuation by looking at its current 10-year price-earnings ratio. During a period when the 10-year p-e ratio has been high (over 20), a new retiree would want to play it safe with an initial withdrawal rate of 4.4% (with a portfolio split 60/40 between stocks and bonds) because it's likely that prices of overvalued stocks will drop in coming years or appreciate at a much slower rate than the long-term average.

In contrast, when valuations are low (with the 10-year p-e below 12), Kitces suggests that a retiree could start with a 5.7% withdrawal, since prices are more likely to trend upward. That rate might not seem appreciably larger, but it could yield real spending that is 10% to 20% higher each year over a multi-decade retirement. The study can be viewed online at the Kitces Report (www.kitces.com/retirementwhitepaper.php) until July 31, 2008.

Kitces' plan is based on the same idea as the 4% solution, except that it permits higher initial withdrawal rates in some market conditions. Financial adviser Guyton, who argues against withdrawal equations that don't allow for flexibility, compares Kitces' recommendation to "driving a car with no brakes and no mirrors" because it doesn't permit any midstream corrections. Retirees who follow an inflexible schedule could feel deprived when the markets are flush and worry when the markets are getting pummeled, he says. Guyton believes initial withdrawals can be as high as 5.2% to 5.6% for portfolios that contain at least 65% stocks. In return, however, retirees must follow certain rules, including maintaining their annual withdrawal at the previous year's amount following a year of market losses.

Kitces acknowledges that "in reality, life is more variable than a spreadsheet can model." His research was meant to demonstrate the impact of market valuation and to yield more flexible retirement-income suggestions, he says, not to prescribe a strict spending pattern indefinitely.

Flexibility is factored into Bengen's revised approach, which permits withdrawals to fluctuate within guidelines. His "floor-and-ceiling strategy" suggests that an initial withdrawal rate of 5.16% would be appropriate if a retiree pares back subsequent withdrawals by as much as 10% of the initial withdrawal during hard times (the floor). On the other hand, a retiree could withdraw extra cash equaling up to 25% of the first-year withdrawal (the ceiling) when the market is strong. The starting rate would vary depending on how much volatility a retiree could stomach. (More details on his research are at billbengen.com.)

Bengen concedes that none of this research is likely to conclude the debate on the best way to safely siphon cash out of a retirement portfolio. "Because there is an element of judgment and uncertainty in the future, there will be no absolute solution," he says. As for the current unsettled market environment, he adds: "In general, I think you are better off planning conservatively initially because you can always make adjustments later."

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