The success or failure of adhering to the 4% rule depends on a both a retiree’s wealth and consumption. The rule, developed by William Bengen, calls for withdrawing 4% from savings at the start of retirement and then adjusting the amount upward each year in response to inflation. Accounting firm PricewaterhouseCoopers (PwC) says the rule may only work for affluent households.
PwC published a paper on the subject as part of an effort to promote its retirement planning product to financial advisers. Though there are some biases in the study, there are two big points worth paying attention to: consumption and wealth.
The 4% rule assumes linear growth in spending. Each year, the retiree is able to withdraw a larger and larger amount from his or her savings. Spending may not match this pattern. Citing work from Morningstar’s David Blanchett, PwC says consumption follows a pattern similar to a smile: higher in the early and late stages of retirement and lower in the middle part. (I’ve seen other research indicating the same pattern.) As a result, a disconnect exists between how withdrawals and spending are adjusted.
For wealthy households, this isn’t a problem. PwC says their high wealth allows for more in-retirement withdrawals to be taken than will be spent. For other households, it can be a potential issue. “Affluent households” who fall into the “mass market” category see consumption exceed withdrawals during five out of the first seven years of retirement, according to PwC. “Mass market households” fare even worse, with consumption exceeding withdrawals during the first nine years of retirement.
The sequence of consumption is a potential problem because it can require a higher amount of savings to be withdrawn early in retirement. To the extent that withdrawals exceed a maximum safe level early in retirement, longevity risk will be increased. This is because there will be a smaller balance to grow, which in turn increases of the odds of a retiree outliving his or her savings.
As far as what to do in response to this information, PwC suggests saving more and keeping a close eye on consumption. The firm also suggests monitoring what it calls “retirement fundedness,” which is the ratio of expected retirement savings to expected retirement expenses. Expected retirement savings is the present value of any future earnings, pension-type income (pensions, Social Security, etc.) and related benefits (e.g., Medicare) and investment savings. Expected retirement expenses is the present value of expected future consumption, debts and any amounts designated for bequests. It’s a ratio that requires many assumptions, but the idea is that all future assets and income streams should exceed future expenses. PwC says that ratios above 105% suggest the retiree is constrained (meaning adjustments may need to be made), while ratios above 145% imply the retiree is overfunded and can use the 4% rule.
While PwC is trying to promote its own proprietary service, the concept of funding expected liabilities first is not a new concept to the world of retirement planning. There is also research calling for a variable withdrawal rate instead of a fixed withdrawal rate, which allows for greater flexibility. (I’ve highlighted articles discussing both concepts below.) The big key is to understand whether your assets plus any pension or Social Security income are able to cover your expenditures without taking too big of a withdrawal—especially early in retirement—and be willing to make adjustments as necessary.
The Week Ahead
The Federal Open Market Committee will hold a one-day meeting on Wednesday.
The first economic reports of note will be released on Tuesday: the February Case-Shiller home price index and the Conference Board’s April Consumer Confidence survey. Wednesday will feature the preliminary estimate of first-quarter GDP and March pending home sales. March personal income and spending and the April Chicago PMI will be released on Thursday. Friday will feature the April ISM manufacturing index, the University of Michigan’s final April consumer sentiment survey, the April PMI manufacturing index and March construction spending.
About The Author - Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here)
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters. © EconMatters All Rights Reserved | Facebook | Twitter | Free Email | Kindle