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.
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 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. A shortfall could result in impoverishment at an advanced age.
The RDR makes this risk explicit and places it under the retiree’s control. Viewed as a tool for advisors, RD R 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 sex
- 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 63-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 $3976. The risk of falling short due to an asset return of less than 4% is estimated at 6.1%.
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 6.1% of them.
Smith also faces the risk of living past age 88, which is not taken into account by the RDR at this time. I am looking into ways to do that for future deployment. At this point, the safe way for him to proceed with the RDR is to assume a long life span.
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 critical variable that is easy to overlook is the assumed annual increase in the draw amount. The table assumes that it is 2%. With a zero increase, the draw amounts in the table would be about 20% higher. Most retirees, however, will want the withdrawal amounts to rise over time.
The RDR has been implemented as an Excel spreadsheet ,which is available for free download at https://www.mtgprofessor.com/spreadsheets.htm.
Jack Guttentag was Chief of the Domestic Research Division of the Federal Reserve Bank of New York, on the senior staff of the National Bureau of Economic Research, Jacob Safra Professor of International Banking at the Wharton School, and managing editor of the Journal of Finance and the Housing Finance Review. He has also been a consultant to many government agencies and private financial institutions, and a director of the Teachers Insurance and Annuity Association, Federal Home Loan Bank of Pittsburgh, Guild Mortgage Investments, and First Federal Savings and Loan Association of Rochester.
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