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If you
retire, how much money can you remove each year from
your savings and make sure you don’t rob your golden
years of the gold you will need to put food on the
table?
In the
past couple of decades, many financial planners had
their clients live by what’s called the 4 percent
solution. Backed by research done in the 1990s, the
solution enables a retiree in the first year of
retirement to take 4 percent out of their total
retirement savings and use it for living expenses. Then,
each year the person can increase the amount just a tad
to cover inflation.
So if the
person retired with $500,000 in savings, the person
could use $20,000 of it for living expenses in year one
of retirement. The next year they would tweak the sum to
cover the cost of inflation. With inflation running at 3
percent, the tweak would be $600. In other words, for
year two of retirement the person would have $20,600 in
spending money from their nest egg, plus whatever they
get from Social Security, pensions or part-time work.
According
to research done by financial planners such as William
Bengen in the 1990s, a person who removes more than 4
percent is taking a relatively large risk of running out
of money prematurely in retirement. He came to that
conclusion after examining numerous market conditions
from the past and applying them to today’s long life
spans. Often people retire in their 60s and live into
their 90s. The 4 percent solution assumes people are
retired for 30 years.
But the
traumatic experience of two horrendous bear markets
since 2000 has caused financial planners to re-examine
old assumptions. After all, embedded in the 4 percent
solution is the idea that an individual will have a
mixture of stocks and bonds that will grow enough to
replenish some of the money the person removes each year
for retirement living expenses. And the brutal truth of
the past few years has been that while the U.S. stock
market has provided a 9.9-percent-a-year gain on average
since 1926, in a single year like 2008, a person can
lose more than 30 percent.
The
realities have been hard on seniors, and especially on
those who have never heard of the 4 percent rule and
simply removed the money they wanted or needed for
retirement expenses. If a person spends too freely early
in retirement and then sees the well going dry at 75,
it’s tough to find a job.
While
research done before the 2000s skirted over periods of
massive losses and especially the Great Depression,
there is renewed interest in peering at brutal times as
well as benevolent times in the stock market.
So new
research by Chris O’Flinn, president of Elm Income
Group, garnered attention at the annual conference of
the Society of Actuaries last week.
O’Flinn
wondered if people could still feel safe removing 4
percent from their savings and whether they could dare
push the limits a little and remove 5 percent.
He went
through history from 1926 through 2009, examining what a
typical retirement portfolio of half stocks and half
bonds would do.
The
conclusion: A person who removes 5 percent of their
money the first year of retirement and then tweaks it
each year to cover inflation stands a 51 percent chance
of running out of money in a 35-year retirement. In a
30-year retirement, the danger of running out is 36
percent. In 25 years of retirement, there’s a 20
percent chance of outliving your money.
A person
who sticks to the 4 percent solution improves the odds
of having enough money. Yet over 35 years, there is a 15
percent chance of exhausting your savings prematurely,
and over 30 years, there’s an 8 percent chance.
The 1960s
were also tough on retirees. A nasty combination of high
inflation and bad returns on investments conspired to
erode people’s savings faster than usual, O’Flinn
said.
Some
people feel comfortable with a 15 percent risk. But if
you want certainty that you won’t exhaust your
savings, history suggests you should be fine if you
remove no more than 3.5 percent of your savings in the
first year of a 30-year retirement.
Of
course, that’s getting pretty lean on spending money.
O’Flinn notes that another way to handle a period like
we’ve encountered in the past few years is to stop
taking any inflation adjustment for a year or more. The
idea is to take as little as possible out of your
savings so that you give the stocks time to make gains
again. If you’ve removed money, it will never have a
chance to heal and prop up your savings again.
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