RETIREMENT SPENDING -- THE 4 PERCENT SOLUTION

Younger investors saving for retirement often ask: "How big does my portfolio have to be before I can retire?" Those nearer to or in the very early stages of retirement might ask:  "How much can I safely withdraw from my retirement portfolio?" The two questions are really different ways of approaching the same critical issue.

 

Based on our research, we believe that if you are a conservative-to-moderate investor at retirement who wants a very high level of confidence that you can maintain your standard of living and keep pace with inflation for a retirement lasting 30 years, you can follow a basic rule of thumb. It is this: You should shoot for a retirement portfolio approximately 25 times as large as your first-year withdrawal. This roughly translates into a 4 percent withdrawal rate in the first year of retirement.

 

THE 4 PERCENT SOLUTION AT WORK: AN EXAMPLE

 

Total first-year spending goal                 $90,000

Less Social Security                                    ($25,000)

Less other income                                    ($15,000)

First-year withdrawal                          $50,000 x 25

Retirement portfolio target                    $1,250,000

 

FIRST-YEAR VS. PER-YEAR APPROACH

A first-year withdrawal target of 4 percent doesn't mean you will withdraw 4 percent of your portfolio's value each year. If you did, your cash flows would be all over the map -- up in some years and down in others -- as your portfolio fluctuated over the short term. The key is to strike a balance between not running out of money prematurely and maintaining a reliable standard of living, adjusted for inflation, from one year to the next. The 4 percent withdrawal rate applies to the first year only. Then, grow the first-year dollar amount for inflation each year throughout your retirement.

 

RESIDUAL WEALTH

Based on a Monte Carlo analysis that runs thousands of simulations of market scenarios, we believe that a 4 percent first-year withdrawal rate should allow you to grow that dollar amount for inflation each year with about a 90 percent probability your money will last 30 years. To put that in perspective, in 89 percent of the probable outcomes, there would be more than $0 at the end of 30 years. In the remaining 10 percent of probable outcomes, you would run out of money earlier.

 

Here's an illustration of what ending wealth might look like at various confidence levels, using as an example a first-year withdrawal of $50,000 from a $1,250,000 portfolio(1):

 

Confidence Level    Portfolio After 30 Years

10%            $6,445,000

25%            $4,050,000

50%            $2,340,000

75%            $1,070,000

90%            $0

 

As you can see, there's a very slim (one-in-ten) chance the portfolio might be worth at least $6,445,000, a 50/50 chance of ending up with $2,340,000, and so on. By the way, at a 95 percent confidence level, the portfolio runs out of money at some point during the 27th year. Also keep in mind that these are future dollars. Assuming a 2.6 percent compound rate of inflation, $1,000,000 30 years from now has a present value of about $463,000. Of course, the first-year withdrawal amount of $50,000 would grow to almost $108,000 in terms of future dollars. You might assume higher inflation, but that would also correspond to higher expected nominal investment returns.

 

NO MAGIC HERE

There's nothing magical about a 90 percent probability, though we think it's a reasonable goal to shoot for. Anything less than 75 percent would probably be undesirable for most, with 50 percent not much more than a coin flip, but you may be okay with an 80 percent or 85 percent probability. And your retirement may not last 30 years. If that's the case, maybe you could get by with a portfolio less than 25 times your first-year withdrawal. Every situation is different.

 

As for what constitutes a "safe" withdrawal rate, a lot depends on the return assumptions, time horizon and probability levels used. Using realistic assumptions -- we estimate a long-term return of 7 percent for a moderate portfolio of 60 percent stocks and 40 percent bonds and cash -- a first-year withdrawal of 3 percent to 5 percent seems reasonable. Anything less than that would require either an extraordinarily large portfolio or drastically reduced spending, while anything much over that would likely result in an unacceptable confidence level.

 

STAY FLEXIBLE

Remember, too, that in the real world, future returns and inflation rates are unknowable in the here and now, at least with absolute certainty. That's why it's a good idea to stay flexible, and why you should view retirement planning as an ongoing process and not a one-time event.

 Rande Spiegelman, Vice President of Financial Planning, Schwab Center for Investment Research

To read more retirement focused articles, please go to: http://www.schwab.com/marketinsight