It’s time to rethink how to make your money last in retirement
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Unless you're lucky enough to have a defined-benefit pension on top of Social Security when you retire, which most US private-sector workers will not, figuring out how to make your money last in retirement can be nerve-wracking.
That's because you can't predict any of the big variables that will affect your savings and investments. For instance, how long you'll live, how long your health will hold up, how the markets will fare or how high inflation will be.
That makes it harder to know how much income you can safely draw from your portfolio every year and not outlive your money.
The most commonly recommended rule of thumb is the so-called 4% rule, which means you spend 4% of your portfolio every year, on an inflation-adjusted basis. So if you retire with $1 million, you take $40,000 the first year and then the next year you take out a little more based on inflation. If inflation is at 3%, you'd withdraw $41,200. Then the next year, if inflation is 2%, you take out $42,024 and so on.
The rule is derived from the research of now-retired financial adviser William Bengen, who based his 1994 work on a simple 50-50 portfolio of US large cap stocks and intermediate-term Treasuries, and assumed a person lives in retirement for 30 years. He has since revised his withdrawal rate suggestions to between 4.5% and 4.7% based partly on an increase in the diversity of investments in the model portfolio.
Limitations of the rule
While the 4% rule is a helpful guideline to consider, it shouldn't be taken as gospel. How much you spend in retirement should be based on your goals, needs and net worth, as much as your desire to not outlive your nest egg.
Some limitations of the 4% rule may be material for you. When you die, your nest egg could be almost as large if not larger than it was on your first day of retirement. For example, Morningstar ran simulations on a $1 million portfolio over 30 years using the 4% rule.
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"(T)he median ending balance was $1.5 million for balanced portfolios and even higher for more equity-heavy portfolios," Christine Benz, Morningstar's director of retirement planning and author of "How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement," noted in a recent column.
That's because the rule is based on a very high probability that you never exhaust your nest egg. "A 95% chance of success implies you will never draw down your assets," said Rob Williams, managing director of financial planning at Charles Schwab.
That may appeal to you if your goal is to leave money for heirs, unless following the rule means compromising your lifestyle and well-being in retirement. And if your goal isn't to preserve principal, you may want to reassess how much more income you can draw from your nest egg without prematurely draining it.
Another downside to the 4% rule is that it doesn't allow for the fact that your spending needs may vary from year to year, according to Williams. Or that life expectancy of people turning 65 is under 30 years, according to estimates from the Social Security Administration, he noted.
Using the 4% rule, but with a twist
For many people, the promise of "guaranteed income for life" is very appealing. That is what Social Security benefits provide, although for many they are not enough to live on.
It's also what annuities can offer. There are many varieties, and their structures and fees can be complex. But basically you can use some or all of your retirement funds to purchase an annuity that will pay you a steady paycheck for the rest of your life.
A new research paper published in October aims to find a strategy that strikes a good balance between people's desire for guaranteed income and their desire to have financial flexibility if their expenses go up or their circumstances change, all while preserving a very good chance of never running out of money.
The researchers compared, among other things, how a retiree with a $1 million portfolio might fare over 30 years using strictly the 4% rule versus taking half their money ($500,000) to buy an annuity and managing the other $500,000 on their own and investing it far more aggressively in equities.
"In general, we find [the hybrid option] does well under a wide range of personal circumstances and preferences," said co-author Mark Warshawsky, CEO of the research firmReLIA Strategiesand senior fellow at the American Enterprise Institute.
By that he means, higher annual income and substantial money left over at the end of the 30 years.
Findings in the paper, which was funded by the American Council for Life Insurers but it had no control over the research, Warshawsky said, suggest that for those with very large nest eggs of $5 million or more, they might fare better strictly under the 4% rule, while those with limited retirement funds (e.g., $250,000) might do better using most of their nest egg to buy an annuity to avoid a high risk of running out of money.
Changing views on helping employees figure out their retirement income
For now, these research results might be viewed as more conceptual than practical because annuities are complex and confusing for many people.
"Annuities are not easy to understand. And the finality of them in most cases has dissuaded people from getting them," said Craig Copeland, director of wealth benefits research at the Employee Benefit Research Institute.
But the option may become more common in workplace plans as policymakers and employers recognize that the shift away from pensions in favor of 401(k)s and other defined-contribution plans has placed a heavy burden on individuals to manage their income streams in retirement.
"It's not just about getting employees to retirement but (helping them figure out) what to do once they're in retirement," Williams said.
For anyone near or just starting retirement, he recommends working with a financial adviser to come up with a sustainable, disciplined way to draw down their nest egg, and to discuss the potential pros and cons of buying an annuity with some of their money. "Those two things can work well together but not (always) in isolation," Williams said.
