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Wes Moss in the Atlanta Journal Constitution – New Verdict on the 4 Percent Rule for Retirement

Recently, the Wall Street Journal caused a stir with an article, “Forget the 4% Rule: Rethinking Common Retirement Beliefs.” The author’s premise is clear: By following conventional rules of thumb, the average retiree is at risk of going broke.

Developed in 1994 by William Bengen, a financial planner from MIT, the 4 percent rule says: A retiree can take 4 percent from his initial retirement assets, and increase that amount every year to account for inflation, assuming a 50-to-75 percent portfolio allocation to stocks.

Bengen published the study in 1994, with data up through 1992, and showed that the worst-case scenario was money lasting 35 years. For a generation that had seen buying power erode through years of double-digit inflation, the results struck an encouraging cord.

Now, the WSJ says 3 percent is a better withdrawal rate.

Suze Orman says work until you’re 70, just to be safe.

Instead of being resigned to meager withdrawals and impossible expectations of stockpiled cash, I decided to recreate Bengen’s study with 25 years of updated market data. Is the WSJ right, and do events like the financial crisis of 2009 or revved up Fed rate activity make the 4 percent rule irrelevant?

People’s lives are not static financial models. Helpful ‘rules of thumb,’ like the $1,000-a-month rule (which says you need $240,000 in retirement assets for every $1,000 you want in income) have staying power because they can be easy to follow and are applicable. Bengen’s rule is just like that.

Here’s an example of the rule in action:

Jane starts with $1 million in her retirement account on Day 1, Year 1 of retirement. She takes 4 percent ($40,000) out for living.

Inflation goes to 5 percent, so in Year 2, Jane takes the same $40,000 plus 5 percent to account for inflation, for a total of $42,000.

In Year 3, inflation soars to 10 percent. She takes her Year 2 amount ($42,000) and adds another 10 percent to account for this inflation.

Each year she rebalances her portfolio back to the original 50 percent allocation to stocks.

Jane’s worst-case scenario is enough cash for 35 years.

Our work recreated the study with retirement withdrawals beginning every year from 1929 to 2009, or 82 separate retirement starting points. We used actual market data until 2017 and ran multiple simulations with conservative average return estimates thereafter: 5 percent for stocks, one or 2 percent for bonds and a range of inflation figures.

● 70 percent of the time (58 of 82 scenarios) retirement funds lasted 50 years or more.

● 30 percent of the time, the money “ran out” – with the worst-case scenario in our study being 29 years.

Bengen’s rule brings clarity to what we can take out from our nest eggs, for how long and what kind of allocation a well-constructed portfolio will have. And, yes, the rule still works.

Here are a few more outcomes from our retesting:

Retirement begins on January 1st, 2000

The S&P 500 kicks off this retirement season with a brutal run of returns: losses of nine, 12 and 22 percent in the first three years. Using actual stock, bond and inflation numbers through 2017, we assume 5 percent stock returns, 1 percent bond and 3 percent inflation. In this model, money still lasts 41 years.

Retirement begins on January 1st, 2008

Using actual returns through 2017, we assume 5 percent stock returns and 1 percent bond returns. Here, we assume you don’t inflate your earnings every year. (Very possible, if you follow the declining spending trend of the average American or don’t have significant housing expenses). In this case, the money lasts 77 years! Spiking to 3 percent inflation, spending goes from $40,000 to $107,000 in the last tested year. Quite extreme, but even then, money lasts 39 years!

Our research surfaced a few new points, as well:

If annual withdrawal rates ever dropped to 2 percent, portfolio growth often turned exponential. For example, if a retiree had a $1 million portfolio and began $40,000 withdrawals in 1950 and, because of the outsized market returns of the 1950s, that amount became just 2 percent of portfolio holdings, the portfolio would have grown to $51 million in 2009 and over $100 million in 2017. This exponential growth is why I’ve deemed this “The Buffett Zone.” Warren Buffett’s 2018 annual letter to investors shows a per-share market value gain for Berkshire stock of 2,404,748%. Yes, that’s almost 2.5 million percent!

On the contrary, if a portfolio endures a particularly bad market stretch and that same $40,000 plus inflation now represents a 6 percent withdrawal rate, funds are in danger of running out. For scenarios beginning in 1965, portfolios were hit by poor market returns and historically high inflation. These factors spiked withdrawal rates and made them difficult to sustain. This caused the worst-case scenario discussed above of 29 years.

Despite the cynicism, the 4 percent rule still works, even over two decades after Bengen published his work.

Ultimately you are in control of what you spend. Whether you are 40 or 80, you flex your spending and saving depending on your needs and the performance of your income or portfolio. The dynamic nature of this cannot be appreciated by a financial model but helps make retirement a reality.

Today’s investors should be encouraged. Bengen’s model – even while mixing and matching return and inflation assumptions – plus some common-sense budgeting, gets most people over the finish line.

Read the full article here.

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