My article last week cited some of the weaknesses of the “4%
rule”, which says that it is probably safe for a retiree to
draw an amount every year equal to 4% of the current value
of a stock portfolio, rising modestly year by year with
inflation. The principal weakness of the 4% rule is that the
retiree does not know and cannot easily control the risk
that is involved.
The major risk is that the rate of return that will
be earned on the retiree’s assets will fall short of the
rate that was assumed in calculating how much the retiree
could withdraw from the assets each month. An additional
risk is that the retiree will live past her expected life
span. Either could result in impoverishment at an advanced
age.
This article proposes a replacement I will
tentatively call the “Retiree Discretion Rule”, or RDR. ,
which is designed to remove the weaknesses of the 4% rule.
The RDR makes the risks explicit and places them under the
retiree’s control. Viewed as a tool for advisors, RDR
provides a framework for a retirement plan that incorporates
the unique needs and concerns of each retiree.
The RDR calculates the initial monthly draw from
the retiree’s assets, based on the following inputs.
- Retiree’s age
- Retiree’s gender
- Value of financial assets
- Annual inflation rate desired
- Age to which retiree wants monthly draws to
last – life span
- Rate of return on assets
Here is an example. Retiree Smith is a 65-year
male, has a common stock portfolio valued at $1 million,
wants his monthly draws from assets to rise by 2% a year,
wants those draws to last until he is 90, and assumes his
financial assets will yield 4% over that 25-year period. RDR
indicates an initial monthly draw of $4218. The risk of
falling short due to an asset return of less than 4% is
estimated at 6.4%, the risk of living past 90 is 18.6%, and
the combined risk of a shortfall from either source is
23.8%.
The risk of a shortfall in the rate of return is
based on a data base of common stock returns during the
period 1926-2012. Over the 673 25-year intervals during that
period, the rate of return on common stock was less than 4%
on 6.4% of them. The risk of living past any age is based on
the mortality statistics used by the Social Security
Administration.
If Smith views a risk of impoverishment of 23.8% to
be excessive, he can reduce the assumed rate of return,
extend the draw period or both. With a 3% rate of return and
draw period of 95, the draw amount falls from $4218 to $3210
but the risk of running out of funds falls from 23.8% to
9.4%.
Another way to use the RDR is to generate a table
of outputs that cover the different cases from which the
retiree is making a selection. A table for Smith would look
like the following.
|
Application of Retirement Discretion Rule:
Initial Monthly Draw Amount and Risk That it Won’t
Materialize For Retiree of 65 With Common Stock
Portfolio of $1 Million |
|||
|
Rate of
Return Assumed |
Target Age
of Monthly Draws |
||
|
90 |
95 |
100 |
|
|
3% |
$3,764/23.0% |
$3,211/9.4% |
$2,816/4.1% |
|
4% |
$4,218/23.8% |
$3,674/10.9% |
$3,289/5.7% |
|
5% |
$4,699/25.4% |
$4,170/12.0% |
$3,800/7.7% |
*Assumes 2% annual increase in
draw amounts
