“I’ve got all the money I’ll ever need if I die by four o’clock this afternoon.”
Since William Bengen’s authoritative study of the subject, the rule of thumb for a safe withdrawal rate in retirement has been 4% of assets. Oftentimes, such as in the textbook for my financial planning class, it is cited as ground truth with very little else to explain why we should accept the number as ground truth.
Despite the vast importance of the safe withdrawal rate – meaning the amount of money that you can withdraw from your assets each year without running out of money – scant little is dedicated to it in textbooks. Pull out too much, and you’ll run out of assets and have to live on whatever you get from pensions and Social Security. Pull out too little, and you’ll have sacrificed an improved standard of living and potentially leave a much higher amount of money to your estate than you intended.
Why is the number so difficult to calculate? There are three main driving factors. The first is that you don’t know when you are going to die. According to the U.S. Centers for Disease Control, in 2009, the median age of death was 78.5 years old. This means that 50% of people in the U.S. will die before that age and 50% of people will die after that age. So, planning for success until age 78.5 gives you a 50% chance of outliving your money.
The second driving factor is that you don’t know what your investments will yield in the intervening time period. If your investments significantly beat the averages, then you’ll be presented with the problem many people want – more money than you expected. However, if returns underperform the averages, then you’ll wind up with less money than expected and face a risk of running out.
The third driving factor is inflation. Inflation is the rise in the cost of goods and services over time. As Yogi Berra once said, “a nickel ain’t worth a dime anymore.” Many of you can probably remember when Cokes were a nickel and a gallon of gas was a dime. In all but the most exceptional circumstances, the same amount of money in the future will buy less than it will now. Therefore, in order to keep up the same standard of living throughout retirement, more and more income will be needed.
Other factors which might affect that safe withdrawal rate include pensions, health, long-term care, and estate planning desires.
More recently, with the increased gyrations of the stock market during the Great Recession, some have come to question the 4% number. Some come out on the side that it’s too low and some have said that it is too high.
Why do the conclusions vary (even, if sometimes, the authors remain the same)? Usually, the conservative conclusions try to protect you from unlikely events, such as living to be 100 years old in a series of bear markets, while the aggressive conclusions accept a willingness to take some risks to enjoy life more when you’re more mobile and able to do more.
So, what’s the right answer? There isn’t one. A good ballpark number can only be determined by your specific situation and goals. Even then, things probably won’t work exactly as you plan them. Instead, it’s important that you have a plan for dealing with deviations from what you expected – both on the down side and on the up side. You don’t suddenly wake up one day and find that you’re 85 and have run out of money or, on the other hand, that you have much more money than you expected but can’t really spend it anymore. There is plenty of time along the way to evaluate where things stand and to take appropriate actions. It’s better to make small corrections as you go than to have to make a big lifestyle adjustment when it’s too late.