Retirement planning formula

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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.