Forget the 4% retirement withdrawal rule

You should plan for much lower returns on your nest egg than what used to be expected, expert says.

By MSN Money producer Mar 14, 2014 7:22AM

Hands holding a nest with money in it © Tetra Images/Tetra images/Getty Images

By Donna Rosato and Penelope Wang, Money magazine

Choppy markets and rising health care costs needn't stop you from having the money for the retirement you want. We asked Wade Pfau, an economist who studies retirement strategies, for advice to help you cruise through the obstacles.


Big idea: The most important retirement rule has changed  

Almost every asset you can invest your nest egg in now looks expensive by historical standards. What's more, argues Pfau, this has big implications for how you draw down from your savings the money you need to live on. If he's right, it throws one of the best-known retirement guidelines right out the window.


When Pfau, a professor of retirement income at the American College for Financial Services, says both stocks and bonds are expensive, he isn't predicting an imminent crash -- the Ph.D. economist is a number cruncher, not a tea-leaf-reading market forecaster. But he argues that basic math suggests asset prices have less room to rise, meaning the long-run outlook is for lower returns ahead.


Based on studies of stock and bond returns since 1926, financial planners had settled on a benchmark for how much a retiree could spend each year without fear of running out of cash. It turned out that a person who invested half in stocks and half in bonds could spend 4 percent of his or her wealth in the first year, adjust that dollar amount for inflation in subsequent years, and still have money 30 years later. That worked in every historical 30-year period, as well as in most computer simulations based on the historical rate of return. Even drawing a hefty 5 percent worked more often than not.


But without strong stock and bond returns to help refresh your nest egg as you spend from it, those old numbers can't be relied on, argues Pfau.


"The probability that a 4 percent withdrawal rate will work in the future is much lower," he says. His new safe starting point: a 3 percent drawdown. That means that if you've saved $1 million, you're living on $30,000 a year before Social Security and any other sources of income you might have, not $40,000. Ouch.


You may be relieved to hear that Pfau's idea is controversial. Michael Kitces, partner and director of research, Pinnacle Advisory, who has worked with Pfau on other research (more on that later), is one of many experts who think that the long historical record is still a decent guide to the future.


Yet William Bengen, the planner who in 1994 came up with the 4 percent rule, says some rethinking may be in order. "I think Pfau has done a great job of looking at the issues," he says. "Market valuations are important, and he may be right."

Here's the story the numbers tell, according to Pfau: The 10-year Treasury recently yielded only 2.6 percent, compared with its 3.5 percent historical average. Current 10-year yields generally tell you the total return you can expect over the next decade. (Even if yields go up from here, today's owners of bonds will suffer a loss of capital, since bond prices fall when yields rise.)


As for stocks, large companies listed on the S&P 500 index are priced at 25 times their averaged earnings over the past decade, according to measurements by Yale economist Robert Shiller. This gauge stands significantly above its average of 16. When Shiller's price/earnings ratio is high, lower returns typically follow over the next 10 years.


As a result, Pfau estimates a 50-50 portfolio of stocks and bonds is likely to deliver a long-run annual average return after inflation of just 2.2 percent, less than half the historical rate. In a study with Michael Finke of Texas Tech and David Blanchett of Morningstar, Pfau found that with returns in that range, taking an inflation-adjusted $40,000 year out of a $1 million portfolio will drain your assets about 57 percent of the time, depending on the pattern of good and bad years. (More bad years early mean you will be more likely to run out.) Ratcheting back to $30,000 lowers to 24 percent the chance you will outlive your savings.


Make the right moves:


Save more if you can. That's the easy takeaway from Pfau. Not that it's easy, especially if you are close to retirement. To get $40,000 from a 3 percent withdrawal rate, for example, you'll need $1.3 million instead of $1 million. Working longer can help, but it won't fill all the gap. Other adjustments you can make, however, can take the sting out of Pfau's message.


Use diversification to stretch your cash. Even given the same long-run returns, a less volatile portfolio will tend to last longer. A portfolio that's not just large-cap stocks plus bonds, but is instead spread out to include small-company stocks, foreign stocks, and other asset classes, Pfau says, lets the safe drawdown from $1 million in savings rise to an initial $35,000 from $30,000.


Stay flexible. You can kick off your retirement with a larger starting income -- closer to the 4 percent rule -- as long as you are willing to correct your course when the market doesn't go your way. For example, in a year when your portfolio falls by 10 percent, you could try to reset your spending at 4 percent of the new, lower amount. If that's not enough to make ends meet, adjust what you can and then plan to skip cost-of-living increases for a few years.

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Mar 16, 2014 7:10AM

"Economics as a discipline is no better at PREDICTION than an astrologer. Until these clowns scientifically track and rate their predictions, they need to stop pretending they really offer anything more than an analysis of the past and 100% accurate hindsight."

It doesn't hurt that they are paid salary by people powerful enough to sway the outcome to favor them first and foremost. Ban all affiliations in money touching- see who thrives and who dies quickly.

Mar 14, 2014 8:17PM
Economics as a discipline is no better at PREDICTION than an astrologer.

Until these clowns scientifically track and rate their predictions, they need to stop pretending they really offer anything more than an analysis of the past and 100% accurate hindsight.

Mar 15, 2014 12:11PM
More "expert' advice. Save more, diversify, stay flexible. Follow these principles folks, and you'll be swimming in money some day.
Mar 17, 2014 8:29AM
"You should plan for much lower returns on your nest egg than what used to be expected, expert says."

As the Right to Work Harder for FAR less movement takes hold in America, just who will be left with any freaking Nest Egg? By far, the vast majority of folks in retirement have been dependent on Medicare and Social Security. The vast majority of Folks don't even realize the massive health-care cost they would have without Medicare.

As Class Warfare has given far more Wealth to those at the Top then those in the Middle and or at the bottom, until folks grow some stones, the vast majority of folks won't have real Retirements anymore.

Mar 15, 2014 1:46AM
There are no experts. Buffett, Icahn, etc. were lucky to strike it early on so they had capital to multiply. But experts, no.
Mar 16, 2014 7:06AM

The real problem here is the word- expert. Basically, the majority of Americans fall into two classes. Both classes cannot continue down the same road they are on without creating war or catastrophic failure. So... change is inevitable. The whole premise of funded retirement is very 20th Century. The Reality of that is- it was predicated on exploitation of things nearly exhausted now.

The ONLY viable retirement strategy is a steady weaning off "salary", a recognition of skills, talents, attributes and creating a small enterprise out of it. While concentrating on your day-job, you should start the sideline as a hobby and grow it consistent with your time and energy.

Mar 16, 2014 2:36PM
I'm extremely fortunate to have more income from Pension and Soc.Sec. in retirement than expenses, but I still have to do things like "pay" myself back after spending cash to buy a new car plus grow the amount a little larger to be able to buy my next car (10-20 years!).

I only keep enough in I-Series Savings Bonds (guaranteed principal, redeemable 1 yr after purchase) or CDs in case I have a surprise expense (new roof, refrigerator, etc.) or a foreign vacation bargain appears, etc.

The rest is in defensive dividend stocks.  I've already made enough gains that if there's a crash like 2008-9 I'll still be ahead of where I'd be in bonds, so I'm sticking with stocks.

Mar 16, 2014 11:20AM
If I took this article seriously, I'd never save a dime and when I couldn't work anymore, I'd get a cup and some pencils.
Mar 15, 2014 12:49AM
So if the premise is that the 10 year yield predicts your return, then wait about 1 year or so when 10 year treasuries are yielding 3.5% or more and you have captured the yield that apparently lets you draw down at the higher 4% rate. 
Mar 17, 2014 4:42PM
Anyone can do better than the traditional approach if you're willing to be non-traditional. For example, you can just fund a real estate loan from your retirement account for 10% annually with interest-only payments. This means three things: You'll double your retirement income, you'll never run out of money, and you'll never touch the principal which means you have an inheritance to leave to your family. Stop relying on Wall Street and start thinking like an entrepreneur.
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