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THE DO-IT-YOURSELF METHOD
Many retirees will prefer to keep control of at least a portion
of the assets they have saved for a retirement nest egg. Let’s
suppose the assets are invested in accordance with the
bottom pie chart
Late Sixties and Beyond
, that is, a bit more
than half in equities and the rest in fixed-income investments.
Now that you are ready to crack open the nest egg for living
expenses in retirement, how much can you spend if you want
to be sure that your money will last as long as you do? My
suggestion is that you use “the 4 percent solution.”
*
Under the “4 percent solution,” you should spend no more
than 4 percent of the total value of your nest egg annually. At
that rate the odds are good that you will not run out of
money even if you live to a hundred. It is highly likely, too,
that you will also be able to leave your heirs with a sum of
money that has the same purchasing power as the total of
your retirement nest egg. Under the 4 percent rule, you would
need $450,000 of savings to produce an income in retirement
of $1,500 per month or $18,000 per year.
Why only 4 percent? It is highly likely that a diversified
portfolio of stocks and bonds will return more than 4 percent
in the years ahead. But there are two reasons to limit the
take-out rate. First, you need to allow your monthly
payments to grow over time at the rate of inflation. Second,
you need to ensure that you could ride out several years of
the inevitable bear markets that the stock market can suffer
during certain periods.
Let’s see first where the 4 percent figure comes from. We
suggested in Chapter 13 that stocks might be expected to
produce a long-run rate of return of about 7½ to 8 percent per
annum. A diversified bond portfolio is likely to produce
something like a 4 to 5 percent return. Hence we can project
that a balanced portfolio of half stocks and half bonds should
produce approximately a 6 percent return per year. Now
suppose that over the long pull the inflation rate is 2 percent.
That means that the corpus of the investment fund will have
to rise by 2 percent a year to preserve its purchasing power.
Thus, in a typical year the investor will spend 4 percent of
the fund, and the nest egg will grow by 2 percent. Spending in
the following year can also grow by 2 percent so that the
retiree will still be able to buy the same market basket of
goods. By spending less than the total return from the
portfolio, the retiree can preserve the purchasing power of
both the investment fund and its annual income. The general
rule is: First estimate the return of the investment fund, and
then deduct the inflation rate to determine the sustainable
level of spending.
There is a second reason to set the spending rate below the
estimated rate of return for the whole fund. Actual returns
from stocks and bonds vary considerably from year to year.
Stock returns may average 7½ to 8 percent, but in some years
the return will be higher, whereas in other years it might be
negative. Suppose you retired at age sixty-five and then
encountered a bear market as severe as the one in 2008 and
2009, when stocks declined by about 50 percent. Had you
withdrawn 9 percent annually, your savings could have been
exhausted in less than ten years. But had you withdrawn only
4 percent, you would be unlikely to run out of money even if
you lived to a hundred. A conservative spending rate
maximizes your chances of never running out of money. So if
you are not retired, think hard about stashing away as much
as you can so that later you can live comfortably even with a
conservative withdrawal rate.
Three footnotes need to be added to our retirement rules.
First, in order to smooth out your withdrawals over time,
don’t just spend 4 percent of whatever value your investment
fund achieves at the start of each year. Since markets
fluctuate, your spending will be far too uneven and
undependable from year to year. My advice is to start out
spending 4 percent of your retirement fund and then let the
amount you take out grow by 2 percent per year. This will
smooth out the amount of income you will have in retirement.
Second, you will find that the interest income from your
bonds and the dividends from your stocks are very likely to
be less than the 4 percent you wish to take out of your fund.
So you will have to decide which of your assets to tap first.
You should sell from the portion of your portfolio that has
become overweighted relative to your target asset mix.
Suppose that the stock market has rallied so sharply that an
initial 50-50 portfolio has become lopsided with 60 percent
stocks and 40 percent bonds. While you may be delighted
that the stocks have done well, you should be concerned that
the portfolio has become riskier. Take whatever extra moneys
you need out of the stock portion of the portfolio, adjusting
your asset allocation and producing needed income at the
same time. Even if you don’t need to tap the portfolio for
spending income, I would recommend rebalancing your
portfolio annually so as to keep the risk level of the portfolio
consistent with your tolerance for risk.
Third, develop a strategy of tapping assets so as to defer
paying income taxes as long as possible. When you start
taking federally mandated required minimum distributions
from IRAs and 401(k)s, you will need to use these before
tapping other accounts. In taxable accounts, you are already
paying income taxes on the dividends, interest, and realized
capital gains that your investments produce. Thus, you
certainly should spend these moneys next (or even first if
you have not yet reached age seventy and a half when
withdrawals are required). Next, spend additional tax-deferred
assets. If your bequests are likely to be to your heirs, spend
Roth IRA assets last. There is no required withdrawal for
these accounts, and you can pass the assets to your heirs tax-
free.
No one can guarantee that the rules I have suggested will
keep you from outliving your money. And depending on
your health and other income and assets, you may well want
to alter my rules in one direction or another. If you find
yourself at age eighty, withdrawing 4 percent each year and
with a growing portfolio, either you have profound faith that
medical science has finally discovered the Fountain of Youth,
or you should consider loosening the purse strings.
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