Retirement: How much can I spend?

If we look back to the 1990’s, we remember defined benefit pension plans in the private sector were becoming a thing of the past.  The Revenue Act of 1978 had ushered into existence what we commonly refer to as our 401(k) or defined contribution plan.  401(k) assets soared and consequently shifted much of the investment risk and retirement savings on us from the employer to the employee.  As retirement neared the question became, how can I create a reliable stream of income from this portfolio of stocks and bonds, and not run out of money.

About this time William Bengen, an MIT graduate and financial planner in California, gave birth to the “4 percent rule”.  The 4% is a distribution rate calculated on the account value at retirement and then adjusted for inflation each year. Bengen studied a 50/50 portfolio, S&P 500 and intermediate term government bonds, over 30-year periods in the market starting in 1926 to find the maximum sustainable rate of withdrawal in the worst period for market performance.

The period between 1966 – 1995 proved to be the worst due to the sequence of returns – it began with 18 years of slow growth and high inflation but ended during a historic bull market.  Low returns on the front end of retirement reduce the accounts principal balance and its ability to recoup.  The power of compounding returns over time is also diminished in the same way funds saved close to retirement are less impactful than those saved early in one’s career.  To illustrate the point, if the order of the returns is reversed during the same period, the sustainable withdrawal rate would have been 8%.

The 4% rule is arguably safe but possibly too conservative.  It is possible that returns are far better and 4% unnecessarily constricts one’s spending in retirement.  At a minimum, the 4 percent rule tends to leave the principal intact over the 30-year period.  Over two-thirds of the time the 4% rule leaves more than double the starting value.  Leaving assets behind to heirs may not be applicable or desirable.  Conversely, one may not have been able to accumulate enough to the point a 4% distribution is adequate.  Additionally, future sources of income such as social security, pension or inheritance may need to be factored in at some point down the road.  All these possibilities may warrant a more flexible approach to spending.  Further, the 4% rule also assumes that you can remain comfortable with a portfolio dominated by equity investments and that future equity returns meet past expectations.

A dynamic analysis that evolves as retirement approaches is usually a more accurate approach.  Planning software today allows advisors to set near and long-term goals, aspirational goals and how to plan for the worst case.  A Monte Carlo analysis runs a thousand trials with varying market returns while in the accumulation phase and in retirement.  The analysis uses a measure of volatility associated with the specific investment allocation along with varying sequence of returns to come up with a statistical measure of success.  Typically having 75% to 80% of the trials come back as successful provides adequate reassurance retirement funds are ample and spending is sustainable.

A successful result is based on the retiree’s desires.  Do you want to leave legacy assets to your heirs or to charity?  Do you want to provide funds for grandchildren’s education?  Or perhaps you want to die penniless?  If the analysis comes up short, it is often too late to save much more, so perhaps one must accept more risks in the portfolio, work longer or dial back spending expectations.  If one has too much, perhaps risk is dialed down to reduce volatility and still have a very high likelihood of success.  But let’s face it, having too much money is usually not perceived as a hardship!

So, in conclusion, the pension is not likely to make a comeback anytime soon and social security is often on shaky ground.  Wealth accumulation is becoming increasingly difficult as more and more young people are saddled with debt.  For the younger investors, save early and often.  Speak with your advisor about running a financial plan to understand how to save enough and maximize your nest egg in retirement.

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