I recently met some of my students from the retirement class Jen and I teach at Cape Cod Community College. After attending my class, Gwen and David came into our Duxbury office for a consultation. They’re from Plympton. David’s a software engineer. Gwen is involved with vacation property management, and they have two kids around my own twins’ ages. Up until now Gwen and David have directed their investments themselves, with occasional help from brokerage houses. Gwen and David have accumulated significant retirement savings thanks to diligent 401(k) contributions, IRAs, annuities and some equity investments.
David’s an avid reader of this column, listens to our radio show and has taken a lot of the lessons over the years to heart. He’s very active in managing their investments. David has even employed strategies like rebalancing their portfolio and diversifying investments among different asset classes. Now Gwen and David are thinking about how they are going to use the wealth they’re accumulating in retirement.
“For the last few years we’ve been planning for retirement using the 4% rule,” David said. It worked for his parents, he said, so he figured it was an excellent place to start.
The 4% rule is a rule of thumb that’s been in financial planner’s lexicon for decades. It says you can withdraw 4% of your portfolio’s value annually throughout retirement without running out of money.
You see, the 4% rule is based on retired financial adviser William Bengen’s research. Back in the 1990s, Mr. Bengen questioned the common belief at the time that 5% was the most appropriate annual drawdown for most retirees. So he researched 50 years of historical investment returns, including severe market downturns. Mr. Bengen determined that even under the most adverse market conditions, 4% would be the optimal drawdown percentage to sustain an investor with consistent income over 30 years of retirement.
While the 4% rule is not the only rule of thumb used to help investors understand the process of wealth distribution in retirement, it is one of the most common because it is easy to understand.
The challenge is that like all rules of thumb, the 4% rule isn’t precise or accurate for every application. Even Mr. Bengen later upped his “rule” to 4.5%! Also, it’s a fixed investment strategy that doesn’t provide the investor with any flexibility.
“You already know ‘buy and hold’ isn’t an appropriate investment strategy,” I said to David. “Do you think that ‘set it and forget it’ will work any better as a means of wealth distribution?”
David looked at me quizzically. He didn’t understand.
As I explained to Gwen and David, just like “buy and hold,” the 4% rule is “set it and forget it” investing. The strategy assumes that you will withdraw 4% of your portfolio’s value each year, adjusted for inflation. The 4% rule is simple, predictable, and it’s easy for people to understand.
There are some fundamental problems with the 4% rule, though. Times have changed since Mr. Bengen created this rule. He assumed that the investor has a mix of 60% stocks and 40% bonds. But different investors will have different allocations of assets, depending on their risk tolerance, their investment goals, and other factors. Gwen and David are no different in this respect.
Another problem with the 4% rule is that it fails to account for other sources of income in retirement, or when they might start. Retirement is still a way off for Gwen and David, and they’re leaving it open to decide when. They plan to work until their Full Retirement Age of 67 in order to collect 100% of their Social Security benefits, but they’re leaving it open to work longer in order to receive more than 100% (Social Security will pay up to 132% if you delay collecting benefits past your full retirement age). Neither of them anticipates they’ll be working a full-time 9-5 job by then, so they may need income from savings to help close the gap before they begin to collect benefits.
Gwen and David are smart investors, and they’ve had to make adjustments along the way to meet their goals as their circumstances have changed. Moving, economic setbacks, having kids, different employers with different retirement plans – all the stuff that life throws at us.
Similarly, Gwen and David’s income needs in retirement won’t be static. If they’re like many investors, they’ll need more income early in their retirement as they travel, develop new hobbies, and enjoy their new lifestyle. Over time they’ll have less of a need to spend money on costly items and travel. But even as those expenses lower, others, such as medical costs, can increase.
A rule of thumb is not the same as having an investment strategy that can be flexible throughout your retirement. A rule of thumb also does not account for your changing needs throughout your retirement. And a rule of thumb does not account for changing market conditions throughout your retirement. All of these and more are factors one needs to consider when developing a retirement income strategy.
Spending too much early in retirement may leave Gwen and David without the money they need later. Conversely, spending too little means they will experience a lower standard of living in retirement than what they’ve worked for — less than what they deserve.
David’s right about one thing: The 4% rule is a good place for some investors to start when it comes to planning for retirement income. But it’s only the first step. An appropriate retirement income strategy should be dynamic enough to accommodate the investor’s income needs throughout retirement.
Gwen and David assume they’ll have a long retirement and, using the 4% rule as a starting point, have a general sense of how inflation will affect their spending over time. But they hadn’t accounted for market volatility or changing income needs during their retirement.
The first step was to help Gwen and David understand how much stable income they’ll have in retirement – in their case, Social Security benefits, annuities and some other investments in their portfolio. That’s enabled them to come up with a budget to understand both fixed expenses and what they’ll have for discretionary spending in retirement.
But rather than being saddled with a hard 4% drawdown, I suggested to Gwen and David that they instead consider implementing an annual spending ceiling and floor. During periods of market growth, they can adapt their spending ceiling to a higher amount. During periods of market volatility, they can spend less. I also introduced them to a Monte Carlo simulation, a predictive computer modeling tool that helps show, over time, how investments can fare as markets fluctuate.
With that in hand, Gwen and David were able to see how a dynamic retirement income strategy can help them have the retirement they’ve worked so hard to achieve – the one that they deserve.
Like them, I encourage you to be vigilant and stay alert, because you deserve more!
Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, a wealth management firm with offices in Falmouth, Duxbury, and Mansfield. Jeff can be reached at email@example.com.
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