The economic news has been bleak for retirees and near-retirees over the past decade: Two recessions and two bear markets. The Standard & Poor's 500 index sporting an average annual return of 0.81 percent over those 10 years. A one-third decline in home values since the market peaked in 2006. Near-zero yields on safe savings.
So shouldn't anyone retired, or soon about to say goodbye to their workmates for the last time, be heartened by the recent uptick in stocks and the economy? Sure—but not too much. In fact, there's an argument to be made that hunkered down is exactly the right stance for retirees, not so much because of the recent financial crisis as the realities of the new global economy.
It all has to do with the question of how much retirees should withdraw from their long-term savings. It's a calculation that gets a lot less attention than how much they save but is just as important in determining a retiree's lifestyle. Some research shows that the common assumptions about withdrawal rates are out of whack and need to be adjusted downward. "People will have to be much more conservative with their assumptions," says Henry "Bud" Hebeler, the former president of Boeing Aerospace and author of Getting Started in a Financially Secure Retirement.
Spend Neither Too Much Nor Too Little
Here's the classic dilemma: Everyone wants to maintain the highest possible standard of living throughout their lives, including old age. Live too high on the hog off accumulated savings early in retirement, spending with abandon, and you might have a lot of fun, but the risk is you'll be forced to make drastic cuts in lifestyle later on. Spend too little, hoarding savings, and the danger is you'll die with plenty of money and a long list of regrets. "How much to withdraw is one of the biggest decisions anyone will ever make," says Ross Levin, a certified financial planner and head of a planning company called Accredited Investors.
The standard solution: the 4 percent rule. In essence, a retiree adds up all the components of her long-term savings, such as 401(k), the stub of a 403(b) from a previous employer, the two IRAs set up years ago, the mutual fund accounts that have been bulked up over the years, and so on. The typical portfolio is assumed to be 60 percent in stocks and 40 percent in bonds at retirement. The first withdrawal is equal to 4 percent of the overall portfolio's value. (The 4 percent figure depends on 60 percent to 65 percent in stock.) The next year the retiree takes out another 4 percent plus the rate of consumer price inflation, and so it goes for the rest of life.
The 4 percent-plus-inflation rule got its power from a series of studies over the past two decades. They mostly relied on Monte Carlo simulations—computer-generated models for calculating the odds or probability of an outcome. The conclusion of the studies in the aggregate was that the maximum initial withdrawal rate with 100 percent confidence of not running out of money over 30 years ranged between 4.1 percent and 4.58 percent, according to a 2006 Journal of Financial Planning article by Jonathan Guyton, a certified financial planner with Cornerstone Financial Advisors, and William Klinger, a software developer. (Their study came up with a figure about a percentage point higher under certain conditions.) The heuristic examples in the studies had portfolios worth $400,000, $1 million, and so forth.
When the Future Isn't Like the Past
Problem is, what if the 4 percent past isn't prologue? What if the simulations and experience behind the withdrawal rule-of-thumb largely reflects an unusually generous period of U.S. equity returns and the damage from the last decade lingers? That's the risk contemplated by three scholarly articles by Wade Pfau, associate professor at Japan's National Graduate Institute for Policy Studies. He too assumes a retiree has a 60/40 portfolio. But he also notes that wealth depletion is taking place more rapidly for 2000-era retirees than for their peers in the Great Depression and the stagflation of the 1970s. His results suggest that a safe withdrawal rate of 2 percent or less may be more realistic. "Hopefully, that is too low for what will happen," says Pfau. "Still, you need to save more than you thought."
That's potentially the understatement of the decade. The implication is dramatic for an aging baby boom generation. The leading edge of the generation born between 1946 and 1964 is eligible for Medicare in 2011. The ranks of those 65 and over are projected to increase from some 13 percent of the population in 2000 to 20 percent in 2030. If these future retirees feel the pressure to switch to a 2 percent withdrawal rate instead of 4 percent to steer clear of the risk of running out of money, they will have to save a lot more money to preserve their lifestyle. More likely, they'll end up embracing a combination of moves: Cut back on spending, work longer to keep earning an income, and save more.
It's important to note that the U.S. is an outlier when it comes to equity market performance, especially since most of the data simulations are run from 1926. For example, in a study published in 1999, economists William Goetzmann of Yale University and Phillippe Jorion of the University of California, Irvine, calculated that the GDP-weighted index of 44 non-U.S. equity markets had a real return of 3.84 percent vs. 5.48 percent in the U.S. The U.S. economy and government survived two World Wars and the kind of global unrest that caused other stock markets to fail. When Pfau used the 4 percent withdrawal rule in a simulation of 17 other major developed market economies since 1900, he found that it worked in only four out of the 17. The withdrawal rate was less than 3 percent for Spain, Italy, Belgium, France, Germany, and Japan. In a global economy with increased competition for profits and markets, does the subdued performance of U.S. stock markets over the past 10 years reflect a "new normal" in an intensely competitive market-oriented global economy? It's a risk to be considered.
Don't Neglect the Fees
More compelling is the recent experience of those who retired in 2000. When it comes to wealth, the 2000 retiree with a 60/40 portfolio is in the worst condition of any retiree since 1926, with only 54 percent of wealth remaining after 10 years, according to Pfau. The other two really bad years to retire were 1929 and 1966; for the former, the wealth remaining after 10 years was about 58 percent, and for the latter, 67 percent. The concern is that poor asset returns early in retirement make it difficult to catch up. Add in low dividend yields, low bond yields, and a percentage or two in fees, and suddenly the 4 percent-plus-inflation withdrawal rate seems risky.
It's worrisome that the results of a number of studies don't reflect imposed fees and actual portfolio performance. Hebeler points toward research showing that the annualized real return of buy-and-hold investors was 8.2 percent for the 20 years through 2009. But the annualized return of the average mutual fund investor was 3.17 percent. "A lot of the difference has to do with cost," says Hebeler. "And investors are often buying and selling at the wrong time."
That's not all. The real value of home equity is down sharply. According to recent research by the Center for Retirement Research at Boston College, mean housing wealth for households of ages 57 to 62 went from $140,133 in 1992 to $200,315 in 2004, and to $121,810 in 2010. Mean mortgage debt rose from $56,088 in 1992 to $121,810 in 2010. Retirees are entering their elder years not only with shrunken portfolios, but also with less housing equity and more mortgage debt than an earlier generation.
Adjust as You Go
To be sure, the 4 percent-plus-inflation mantra is a guideline, a rule of thumb. Actually figuring out a safe withdrawal rate is immensely complicated. Coming up with a reasonably safe number involves making guesstimates of life expectancy, deciding the importance of leaving a financial legacy to the kids, the willingness to put money into stocks and other risky assets, and a judgment about reactions to market implosions and business cycle downturns. What's more, while the financial services industry often stokes fear, the reality is that most people are remarkably creative at controlling their spending and coming up with ways to make money on the side. The safe withdrawal rate isn't a static number. It's dynamic, and it can be adjusted over the years.
Nevertheless, the message of the past decade seems to be that caution rules. Perhaps it calls for invoking the financial version of Pascal's wager. Pascal is famous for his answer to the question, "Is there a God, or is there not a God?" Of course, there's no real answer to the question. But Pascal argued that rationally, we should bet on God's existence since, by living a moral life, we have everything to gain if we're right and little to lose if wrong. Peter Bernstein, the late dean of finance economists, was fond of recommending that people think through a financial version of Pascal's wager and bet on the side of low real returns. No one can pierce the investment fog of the future. But you don't want to be running out of money when you're 85 years old in 2030.
Farrell is contributing economics editor for Bloomberg Businessweek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace.