Sunday, June 07, 2015

The 4% Withdrawal Rule Works In Retirement Under Any Scenario.

 Most retirees try to stay conservative in their investments and don't want any downside surprises therefore so much of their retirement income are in more stable income producing investments like CDs, bonds, or money market funds.  However, in this decade of low interest rates, where a  three year bank Certificate of Deposits gave you a paltry 1.2% and the ten year treasury bond gives a meager 2%, what is a saver to do for stable income?  Many financial planners are worried that with low interest rates, the 4% rule is no longer safe and are telling their clients that they may have to live on less retirement income to preserve their savings.  There is one planner who stated that a retiree cannot take out more than 1.8%, with inflation adjustments, yearly to ensure a 100% confidence that he or she will not run out of money.  In this doom and gloom environment is the 4% withdrawal, with inflation adjustments, still conservative enough to ensure that the retiree will not run out of money before they pass away?  The answer is yes!

The origin of the 4% withdrawal rule came about in a famous Trinity study in 1996 and updated in 2011 that showed that an inflation adjusted 4% withdrawal rate, with the proper asset allocation will allow the retiree to not run out of money during his or her lifetime.  The 4% rule is based upon the  running of over a hundred 30-year simulations from 1926 to 2014  and found that in the worst case scenario that a 4% withdrawal rate, adjusted for inflation, would last a lifetime, with a proper asset allocation.  The 4% withdrawal rate was established as a floor not as an average withdrawal rate and represents the worst case scenario.

For some reason, many financial planners forgot that the 4% withdrawal rule was the floor and in this low interest rate environment was telling their clients that they need to take less (3%) to ensure that their money does not run out.  Therefore, many retirees will probably end up living way to frugally and have three to five times their initial savings when they pass away.  In fact, an article by Michael Kitces showed that the average withdrawal rate for the entire scenarios is close to 6.5%!

As teachers with a TDA that gives us a fixed return of 7%, the low interest rate scenario is actually beneficial since inflation is only 2% (actually 1.29%) and that means that our TDA is appreciating.  However, in the long run we do need equities, be it mutual funds, ETFs or stocks to combat the eroding effects of inflation.  See my post on that Here.  Therefore, make sure you have asset producing equities as part of your retirement portfolio.  The suggested asset allocation is between 50% and 75% in equities.

Finally, if you see that your retirement fund is getting too large, say over 50% of the initial fund at retirement, it might be a good idea to ratchet up your withdrawals by a percentage point or from 4% to 5%, unless you want to leave an oversized inheritance to your heirs.  Its a good idea to check your portfolio yearly and rebalance it to ensure you are following the right path in your retirement journey.


Anonymous said...

Nice article, I learned quite a bit about how it works and your citations are very informative. I take it that the TDA acts as the bond fund component in the asset allocation if its in fixed?

Anonymous said...

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