If you started your retirement with a $1 million investment portfolio, how much could you draw out every year without risking having the account go to zero before your death? Let’s up the ante and require that the amount removed be increased to match inflation every year, keeping the real spendable value of the withdrawals constant.
According to a 1994 study, the short answer is that 4% for a $1 million portfolio would be $40,000. The study assumed that the portfolio was split equally between stocks and bonds. That portfolio mix and withdrawal rate were backtested against actual financial market performance for all 30-year periods from 1926 to 1991. In no 30-year period did the portfolio balance reach zero. The safety of the 4% rule has since become ubiquitous, mentioned in personal finance books and state and federal websites.
New research by four college professors has cast some doubt on the reliability of the 4% rule. In The Safe Withdrawal Rate: Evidence from a Broad Sample of Developed Markets, professors Aizhan Anarkulova, Scott Cederburg, Michael S. O’Doherty, and Richard Sias explore a more extensive data set for testing portfolio performance. We have an additional 30 years of data since the 1994 study was done, but the authors also add data from other countries. For example, Japan’s stock market experienced a nominal -9% return over the 30 years from 1990 to 2019—taking inflation into account brings the real return down to -21%. They also incorporate financial market data going back to 1890, ending in 2019 (before the economic problems from the pandemic developed). They tested a portfolio that was 60% equities and 40% bonds. The results were not encouraging:
- A retired couple using the 4% rule (with inflation adjustments) faces a 17.4% chance that the portfolio will be exhausted before both have died.
- To bring that probability down to 1%, they would have to drop the withdrawal rate to 0.80%, just $8,000.
- If this couple is willing to accept a 5% risk of going broke, they could begin with a 2.26% withdrawal rate, that is, $22,600 from a $1 million portfolio.
- As longevity increases, the chance of running out of money before death goes. That 2.26% rate is suitable for those retiring now; for today’s newborns, the authors project that the safe withdrawal rate will be only 1.95%.
These results are sobering, but they also need more context. Most importantly, the 4% rule need not be adhered to rigidly. If one retires when the markets are performing well, taking 4% from the portfolio may be less than the total return generated, so the portfolio can still grow larger, providing even more cushion. During periods of poor market performance, especially early retirement, one may reduce spending, taking less than 4% not to impose more significant compromises in the future. One may wait to start drawing down from the portfolio, delaying retirement until age 70 or even later, which significantly diminishes the chance of running out of money before death because death becomes more likely within 30 years.
Making the decision to retire can be one of the most thrilling yet frightening times of your life. Our retirement planning services identify the right questions and concerns and help you find solutions so that you can enjoy your retirement. Visit us at https://www.lptrust.com/our-services/retirement-planning/ for more information.
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