At a recent editorial meeting here at Bankrate, one of my colleagues suggested we run a story challenging the rule that retirees withdraw no more than 4 percent from their portfolios during retirement. It seemed to him that the rule was too rigid and not applicable in every situation. For example, if a retiree's portfolio had strong capital gains one year, why not take out some extra money and use it for a major purchase, like a car, instead of taking out a car loan?
That argument flew in the face of everything I'd read over the years in the Journal of Financial Planning and elsewhere. I piped up that scores of studies have shown that 4 percent to 5 percent was the most retirees dared to withdraw from their portfolios if they wanted retirement income to last for 30 years. Those precious flush market gains help investors get through the tough times, I said. Furthermore, T. Rowe Price just published a study showing that, over the previous decade, when investors experienced two nasty bear markets, retirees would have fared better if they'd reduced their withdrawals for a period of three years after each market bottom.
Maybe I've been brainwashed. Or maybe my colleague is too cavalier about retirement planning.
The study's findings
Let's go back in time for a moment to Jan. 1, 2000. It would have seemed like an ideal time to retire. Over the previous two decades, stock market investors enjoyed outsized double-digit gains (on an annualized basis, nearly 18 percent), culminating in 20 percent-plus returns in each of the five years from 1995 through 1999. It all seemed like sunny days would be ahead. But in hindsight, the sunny days were behind us. The following decade produced violent storms.
The study examined the effects of market turbulence on a portfolio worth $500,000 on Jan. 1, 2000. The retiree -- let's call him Sam -- planned to withdraw 4 percent, or $20,000, the first year, increasing that annual withdrawal amount each year by 3 percent, in line with expected inflation. Sam's portfolio had 55 percent invested in stocks and 45 percent in bonds. At the outset, this portfolio's odds of success in generating enough income for 30 years were pretty good at 89 percent, according to the study.
The table below shows how much that $500,000 portfolio would be worth as of Dec. 31, 2010, under four different scenarios.
|Account status||Portfolio value||Monthly withdrawal amount||Odds of success*|
|At retirement on Jan. 1, 2000||$500,000||$1,667||89%|
|Results as of Dec. 31, 2010, assuming four different strategies:|
|OPTION 1: Continue withdrawals as planned||$334,578||$2,307||29%|
|OPTION No. 2: Reduced withdrawals by 25% for three years after each bear market bottom||$386,113||$1,493||84%|
|OPTION No. 3: Take no annual inflation adjustments for three years after each bear market bottom||$352,367||$1,990||69%|
|OPTION No. 4: Switched to 100% bond portfolio after first bear market bottom on Oct. 1, 2002||$270,669||$2,307||0%|
If Sam had taken his withdrawals as planned, his portfolio would have dwindled to a dangerously low level -- and his odds of success in having enough money for another 20 years would be 29 percent. That's not good. If, at the end of the bear market in September 2002, Sam had bailed out of stocks and switched to a 100 percent bond position, his portfolio would be seriously decimated. The study gives him a zero percent chance of having enough money for retirement, using Monte Carlo simulations -- which are sophisticated projections of 10,000 possible future market scenarios. Zero percent is, well, really bad. Let's face it, 10 years into retirement, it's tough to think about putting together a resume and pounding the pavement.
The best outcome occurred if Sam had reduced withdrawals by 25 percent for three years after the market hit bottom in September 2002. His chances of making it another 20 years would be 84 percent -- not fantastic, but pretty good. If he'd continued taking 4 percent withdrawals without the extra money for inflation, his chances of success would be 69 percent.
Christine Fahlund, a senior financial planner with T. Rowe Price, notes in the study that retirees need to pay attention rather than take a passive approach as they take withdrawals. And selling equities at the market bottom is a bad move since investors miss out on a subsequent rebound, she notes.
What if a retiree enjoys big market gains one year? Should the 4 percent withdrawal rule prevent him or her from splurging on a big-ticket purchase? "One year of robust cap gains is not a reason to spend that money on a car," says Fahlund. "You need up years to offset the down years."
I'd love to hear how retirees managed their portfolios through the last decade. What do you think of the 4 percent rule? How did you get through the tough times? Share your insights.
Check out Bankrate's Retirement Realities series. We'll be adding stories to it throughout the year.
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