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How much can you safely spend in retirement? Or, put more technically, what percentage of your retirement savings can you withdraw each year so that your savings last as long as you do? The answer is key to sound financial planning. Before retirement, it informs your decisions on when to retire and how much to accumulate. After retirement, it becomes even more important: Spend too much, and you could wind up impoverished in old age. Scrimp too much, and you may deprive yourself unnecessarily and miss out on enjoyable experiences. The good news for all future retirees is that an approximate answer exists: Without significant risk of outliving your portfolio, you can spend about 4 percent in your first year of retirement and that same dollar amount, adjusted upward for inflation, in subsequent years. Thus, if you have a $2 million portfolio (average for Legal Times readers), your retirement budget from savings is $80,000 a year. Of course, that relatively clear answer — known as the 4 percent rule — hides some important caveats. BACK TO THE PAST The 4 percent rule is not intuitive. Indeed, on first reflection, you might think that you could spend your portfolio’s average return. If that’s 8 percent, you might take an 8 percent withdrawal rate. Some years your portfolio wouldn’t earn 8 percent, but the good years with above-average returns would balance out the bad years, right? Alas, that doesn’t work. The order of those returns, not just the average, is significant. If your portfolio hits a market downturn at the start of retirement, you will draw down the principal more rapidly. Any above-average returns further down the road may come too late to rebuild your savings. For example, suppose a retiree starts with $2 million and spends $160,000 (8 percent) each year. According to the calculator at Fireseeker.com, a Web site devoted to evaluating retirement plans, a portfolio with this withdrawal rate would have survived a 30-year retirement (during the 20th century) only 13 percent of the time. In other words, 87 percent of the time, a retiree would have gone broke. If the average return doesn’t work, what does? A number of researchers have used historical backtesting to answer this question. That is, they have taken past returns for U.S. stocks and fixed-income instruments (such as bonds or commercial paper) and examined what withdrawal rate would have preserved a portfolio long enough. Several studies use data from the 1920s to the present day, although one often-mentioned study, by retired engineer John Greaney, goes back to 1871. The answer to what works turns out to be about 4 percent — assuming the retiree does certain things. Greaney’s study, for instance, assumes about 75 percent of the retiree’s assets are in a range of stocks (or mutual funds) that mimics the S&P 500, a retirement of 30 years, and low investment costs (0.20 percent of the portfolio). If you have a lower percentage of your portfolio in stocks, a less-diversified stock portfolio, a longer retirement period, or expensive investment fees or advisers, your withdrawal rate should be lower. ( Greaney’s site offers a downloadable spreadsheet that lets people run personalized calculations. Fireseeker.com does the same online.) Does this mean that the 4 percent rule guarantees success? Unfortunately, no. In fact, there are sobering reasons to think that the high historical returns of U.S. stocks might not last through your retirement years. To start with, much of that return came from stock dividends, which were far higher in much of the 20th century than they are now. Moreover, the U.S. economy soared during the 20th century. Will such economic success repeat over your lifetime? That would certainly be nice, but it seems rash to bet the comfort of your retirement on it. Just consider the economic problems that may result from underfunded government programs such as Social Security and Medicare. In their book The Coming Generational Storm (2004), Harvard economist Laurence Kotlikoff and Dallas Morning News financial journalist Scott Burns warn that the federal government’s efforts to meet these spending obligations may well come at the expense of the economy and low inflation. Thus, a 4 percent withdrawal rate is a sound place to start, but being a bit more cautious with your retirement seems prudent. HIGHER RATES? That said, some financial researchers argue there are ways to improve the safe-withdrawal rate. Their studies into increased diversification and alternative withdrawal strategies suggest that retirees can both be safe and withdraw more money. The initial backtesting studies were typically done with portfolios containing some combination of bonds, money-market accounts, and the stock of large U.S. companies. That’s only part of the range of available investments, and adding additional asset classes that interact with financial markets in different ways should, in theory, improve portfolio performance. Some backtesting supports this hypothesis. Earlier this year, Dean Fikar, a doctor who retired from his radiology practice at age 47, tested a range of portfolios that included foreign stocks, commodities, small-cap value stocks, and inflation-adjusted bonds. The results, available online, suggest that balanced portfolios including these asset classes may permit withdrawal rates of up to 6 percent. Commodities and small-cap value were especially helpful (particularly when they’re paired together, Fikar told me). There also is good news if you have the flexibility in retirement to hold the line on what you withdraw after bad years. The early studies frequently assumed a relatively static annual withdrawal modified only for inflation. In other words, the model retiree was assumed to have fixed living expenses that did not change and whose cost rose at the rate of inflation every year. In an analysis published this March, financial planner Jonathan Guyton, along with software developer William Klinger, examined what might happen if a retiree had more flexibility in the amount of his withdrawal from year to year. In general, Guyton’s retiree doesn’t adjust his withdrawal upward for inflation following bad returns in the market. (I’m simplifying this; the details of Guyton’s various decision rules are covered in papers in the Journal of Financial Planning.) If a retiree can reduce spending in hard times — which is probably the natural tendency — Guyton’s research suggests that it is possible to use a withdrawal rate of more than 5 percent. (And this study did not incorporate the apparent boost from commodities that Fikar identified.) So you might be able to start out spending significantly more in retirement — you simply have to be prepared to cut back if times get rough. Just this September, a new retirement calculator went online that allows people to test retirement plans using different withdrawal strategies (including Guyton’s). The site runs a “Monte Carlo” mathematical simulation to test a wide range of possible economic scenarios using an individual’s basic financial information. The calculator runs about 10,000 iterations to build its model, which helps ensure a valid number of samples, according to creator Jim Richmond. Users can test for themselves how likely their retirement plans are to succeed if they can reduce spending at times — the financial condition, I suspect, of most Legal Times readers. WHAT TO DO It thus seems that the 4 percent number is being pulled in opposite directions. On the one hand, increased portfolio diversification and flexible withdrawal strategies may lift that number higher. On the other hand, lower stock dividends, combined with whatever harsh economic blows the future may hold, could push the safe withdrawal rate lower. Will the positive pulls outweigh the negative pushes over the course of our future retirements? I don’t know. No one does. But even with this uncertainty, we can draw some practical conclusions about what to do. • First, diversify broadly. The common pension portfolio of 60 percent U.S. stocks and 40 percent U.S. bonds can be improved. Consider adding real estate investment trusts, foreign stocks and bonds (including those from emerging markets), inflation-indexed bonds, and commodities. Fortunately, both mutual funds and exchange-traded funds are beginning to make commodities more available to the individual investor, and I suspect Wall Street will continue to expand products for this asset class.

• Second, build a margin of safety into your elder years by excluding Social Security payments from your retirement planning. While the payout from Social Security isn’t lavish (about $12,000 a year on average right now), any such inflation-indexed pension will greatly help if your portfolio takes a big hit. • Third, recognize that taking a withdrawal higher than 4 percent remains risky. Yes, some research indicates that higher withdrawals may be possible, and you probably will be able to cut back if times get rough. But it seems the one historical record we have was financially kind. And if the future is financially worse and medically better (meaning that you have to fund a longer retirement because of life-extending medical advances), you’ll appreciate that you prepared.

A withdrawal rate lower than 4 percent should have special appeal to those who are extra cautious or who expect to retire unusually young. One 2000 paper by financial planner William Bengen suggested that a portfolio would last forever with a 3.5 percent withdrawal rate (within the parameters of his study’s assumptions). Bengen dubbed this finding the Methuselah withdrawal rate, after the longest-lived man in the Bible. The Methuselah rate is what I use for my own retirement planning — partly because of my relative youth and partly because of my concerns about what the next 50 years may hold. That’s conservative, but if markets do well, my heirs will party.
Robert L. Rogers, associate opinion editor at Legal Times , writes the Legal Tender column on personal finance. E-mail Rob with comments or suggestions for future columns.

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