The Retirement Paycheck

January 29, 2016

It has now been over 20 years since Bill Bengen introduced his 4 percent withdrawal rate concept. What he and his computer produced, in 1994, became one of the most widely referenced general “rule of thumb” retirement planning concepts. It found that retirees who withdrew 4 percent of their initial retirement portfolio, balanced between equities and fixed income, then adjusted for inflation each year, could create a “paycheck" that should last 30 years. Hardly a week goes by without seeing some type of headline news discussing the viability of the 4 percent spending rule. It’s no wonder that retirees may be more confused now than ever.

 

Over the last 25 years, much has occurred in the capital markets, including three bull markets, two bear markets, and historically low fixed-income yields making now as good a time as any to reflect on this concept.

 

First, a critical view of the “4 percent rule” is based on the fact that much of the earlier research was based on modeling of historical asset class returns. While this approach has its merits, the major limitation is that it doesn’t consider current market and economic conditions. In today’s environment of lower than expected future equity returns and sustained low interest rates, these factors can’t be ignored.

 

Second, most well-thought-out research frames the 4 percent target as a rule of thumb with trade-offs. As with anything in financial planning, guidelines are a starting point and shouldn’t be taken as much more than that. Retirees need to consider their own personal situation when managing longevity risk, such as: their goals, planning horizon, portfolio allocation, spending habits, and comfort level.

 

Third, the rule of thumb assumes a dollar inflation-adjusted spending program. This means that, at retirement, the retiree spends 4 percent of his or her portfolio and adjusts that amount annually for inflation. In reality, very few retirees actually stick with such a strict policy. Further, and more important, with such a model, the spending amount is adjusted annually for inflation but completely ignores portfolio performance. In periods of poor market performance, particularly at the onset of retirement, the retiree is actually spending a greater percentage and, if left unchecked, exposes the portfolio to longevity risk.

 

At Windsor, one of our top priorities is for clients to enjoy good cash flow during retirement without the fear of running out of money. No doubt that spending in retirement will continue to be a major concern for retirees. Here’s how we suggest retirees approach the 4 percent spending rule.

 

* Understand this rule of thumb is just a starting point of analysis and should be used as a modeling tool to help gauge portfolio longevity. It also assumes you maintain a balanced and diversified portfolio.

 

* Remember that management costs can affect portfolio longevity. Paying a high management fee (1% or more) can reduce the probability of success by 5% or more.

 

* Embrace a spending strategy (budget) that considers market performance and allows for flexibility on an annual basis.

 

These three principles are general in nature. We recommend communicating with your Windsor representative to make sure your spending goals are in-line with your portfolio’s longevity expectations.

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