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Retirement planning formula

By Jennie L. Phipps ·
Sunday, February 27, 2011
Posted: 10 am ET

If you're feeling cerebral today, get a cup of coffee and contemplate this.

You only have to read three or four retirement planning stories before you know that virtually all of the retirement gurus believe that no one should plan to take more than 4 percent per year out of his or her retirement savings for fear of running out of money and having to eat kibble.

Every once in awhile you run across a maverick who says something radical like, "In a good year take 5 percent." But that person gets stomped on pretty quickly. For instance, my colleague Barbara Whelehan trounced that suggestion when it arose in a editorial meeting a couple of weeks ago.

So when I ran across a study by Wade Pfau, an associate professor at the National Graduate Institute for Policy Studies in Tokyo, that discounted the 4 percent rule in favor of a savings guideline, I was interested. I believe his thinking is particularly useful for anyone who is in the early stages of planning for retirement.

Pfau says that because over time investment returns tend to move back toward the average -- a mathematical theory known as mean reversion -- you actually will need to save more money if you retire at the end of a bull market than you will if you retire at the end of a bear market. That's because, at the end of the bear market, your retirement savings will begin to grow, even if you are already in retirement. While at the end of a bull market, your returns are likely  to fall.

Given that, Pfau uses 20th century stock market history to calculate the percentage of income someone saving for retirement needs to put away annually based on how much money the saver intends to put in stocks compared to bonds and how many years he is able to save. His results are in a complex table that I can't reproduce here, but you can download the study for free from Pfau's website.

But here's bottom line that affects many of us: If you can save for 30 years and you think you'll live for 30 years in retirement and you invest your savings in a 60/40 stock-bond split, then you ought to be putting away 16.62 percent of your income annually in order to replace 50 percent of your income after retirement before adding in Social Security, pensions, etc.

Starting early and saving longer helps. If you can save steadily for 40 years, in this scenario, you only need to save 8.77 percent annually, which sounds a lot more do-able.

If you are committed to this much savings, Pfau says you won't have to worry about the 4 percent rule because no matter how the return on your investments change during your retirement, you still will be able to take out enough to replace 50 percent of what your income was during your working life, adjusting annually for inflation. Add that amount to Social Security, pensions, part-time work, inheritances, whatever, and Pfau predicts we savers can afford steak for our entire retirement.

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March 04, 2011 at 5:10 pm

These are rules of thumb...that is all. Personally, I would run Monte Carlo to solve. That way you would have success percentages instead of generalized rules of thumb and be able to figure out how to "die broke" if that is your goal. It all relates to your starting point, goal and what you are solving for. Maintaining/growing legacy assets can be a goal for other people as well.

Using rules of thumbs for such a complex personal calculations over an entire lifetime is problematic. Use Monte Carlo and run lifetime cash flows. Also, anticipate a HUGE increase in health care costs, modest equity returns and ZERO Social Security income. Personally, I am not concerned about huge lifetime inflation increases. I think building in the other variables are more important and will compensate for huge inflation.

In terms of allocation, put your money at risk for the return that you need to meet your goals with an upper expected rate of return of no more than 9%. The more you have saved over time, the lower your expected rate of return should be...not necessarily the older you are. There is a difference. For an extreme example, if you are 60 and want to retire in 5 years with nothing saved, (without commenting on your inability to plan), invest to garner a modest return...don't gamble. This is a common problem I see.

Bald Eagle
March 01, 2011 at 3:52 pm

I'm curious if the 4% upper-limit on withdrawals contemplated by Wade Pfau and the other authors here assume that a portion of the principal in the retirement account will remain to be passed along to heirs. I've run across several such assumptions (part of the principal remains for heirs) on the part of advocates for this "don't take out more than 4% from your retirement accounts" approach.

Also, it seems like concentrating on this "don't take out more than 4%" only tells half the story. It would think it may take a combination of conservative withdrawals (probably around 4% or 5%) as well as careful control and some reduction of expenses to have a financially successful retirement.

Not sure I buy hard and fast rules like "everyone needs to have 70% (or 80% or 100%) of pre-retirement income" and "don't spend more than 4% (or 4.5% or 5.0%) annually of your retirement accounts" during the withdrawal phase or you'll be eating cat food for the rest of your life.

I would suspect it takes careful management and balancing of both withdrawals and expense control, not just these hard and fast rules that will lead to a financially successful retirement.

At any rate, I'll need to figure out the right combination of withdrawal rate and expense reduction and control fairly soon since I'll be retiring about a year from now. I think everyone is a bit different on how they handle the withdrawal rate.

Good "food for thought" article.

Wade Pfau
February 28, 2011 at 1:49 am


Thank you for writing about my new article. I think you did a great job representing it here.

I would like to just add one comment. When you mention about the concerns with withdrawing 5% or more, I do share those concerns. An implication of my research is that sometimes it is okay to withdraw much more than 4%, such as for a new retiree in 1982, for example.

But for recent retirees since about 1995, I am much more concerned about 4% being too high rather than too low. In this regard, I share the concern of your colleague Barbara Whelehan that now is not the time to be discussing higher withdrawal rates.

An implication of my "safe savings rates" is that retirees should have saved enough that they can meet their desired retirement expenses using a withdrawal rate below 4%. Because of the concern I just mentioned, I don't think that 4% can be considered as a safe withdrawal rate for recent retirees.

Thank you again and best wishes, Wade Pfau