Mark Goodfield (aka The Blunt Bean Counter) takes a look at the popular rule-of-thumb “four per cent rule”.
The pandemic has brought retirement savings front and centre for far too many of us.
In some circumstances, people have lost jobs or their own small businesses that they expected to work at until retirement.
In other cases, people may be succeeding financially but have become more contemplative during COVID. They have begun to think about the long term and what they really want out of life. Maybe it is time for a change in career or time to retire early while healthy and still invigorated. (Full disclosure: I am one of the people in this group and made the decision to retire from public accounting at the end of 2021.)
Some have even decided to retire early and follow the advice of Mike Drak, Rob Morrison and Jonathan Chevreau in their book Victory Lap Retirement. They say people should leave their day job behind once they’ve reached financial independence, and work at something they love or always wanted to do to make some supplemental income.
Canadians who pivoted to retire early caused many financial advisors to pull their hair out. They typically advised clients to just push through the next couple years, as there is too much financial uncertainty to retire early. But based on what I have seen and heard, early retirements have not been uncommon, despite not necessarily being the financially prudent thing to do. (Although if you listen to the Michael Kitces podcasts that I will reference in this series, you will hear his research that many people should have been retiring early for years, assuming they continued to work part-time at a minimum. Read on to learn more about Michael Kitces.)
How to make your nest egg last
And that’s why COVID has prompted me to revisit this series. For those retiring soon, or just planning for the future, it’s a great time to rejig these topics with some new research and expert opinions. You will be pleased to know that I have learned restraint over the last six years: The 2021 series will be ‘only’ a few parts and a mere 3,200 words give or take.
I will stop here today. The next 1,600 words or so require a clear mind, as retirement planning and determining a safe withdrawal rate in retirement are surprisingly academic topics. I will discuss this methodology in Part Two of this series and am also looking forward to reviewing a couple of the top retirement experts’ studies and suggestions.
In this instalment, I discuss a study on the subject by Michael Kitces, a preeminent retirement expert in the United States. We’ll analyze his views on a safe withdrawal rate in retirement. Keep in mind that the safe withdrawal rate is then used to reverse-engineer your required nest egg for retirement.
Seven years of good markets
Over the seven years since I wrote the retirement series, unless you were GIC-centric or Canadian-equity-centric, you likely would have had above-average stock market returns. Consequently, your sequence of returns (whether your returns are strong or weak at the beginning of your retirement) would have likely been advantageous to your retirement. I personally have not seen anyone fall off the rails from their retirement plan, but seven years of relatively good markets is not exactly a great sample size.
The famous 4 per cent withdrawal rule
My 2014 series centred around what is the most commonly accepted rule of thumb for retirement, the 4 per cent withdrawal rule. Created by William Bengen, this rule says that if you have an equally balanced portfolio of stocks and bonds, you should be able to withdraw 4 per cent of your retirement savings each year, adjusted for inflation. Those savings will last for 30 years. So, if you need $100,000 a year to live in retirement, you will need a nest egg of $2.5 million ($100,000/.04).
The 2014 series discussed some of the deficiencies experts feel are inherent in the 4 per cent rule: the withdrawal rate doesn’t take income tax into account; it ignores management fees; the equity portfolio lacked international diversity (as it was US centric); that it was premised on historically higher interest rates for the fixed income (bond) portion of the portfolio and used a constant set 4 per cent withdrawal rate.
Since I wrote the initial series, Michael Kitces has come to the forefront as one of the great retirement researchers and planners in the United States. He has written several articles on the 4 per cent withdrawal rule. Mr. Kitces is not only a great researcher, but he is also a very engaging speaker, who is able to passionately break down a complicated topic into plain English. Look for his YouTube podcasts that I think you will find highly informative and should listen to if you are interested in what your withdrawal rate should be in retirement.
Michael Kitces on the 4 per cent withdrawal rule
Mr. Kitces has written and been interviewed about the 4 per cent rule many times over the years. He has noted the following findings in respect of the 4 per cent rule:
1. The three worst retirement start dates in history were 1907, 1929 and 1966. These form the floor of the 4 per cent rule. It is extremely important to understand that the historical safe withdrawal rate of 4 per cent is not based on historical averages (if they were, he notes the withdrawal rate would be much higher), but they are based on the three worst historical 30-year retirement periods noted above. These three worst periods would have allowed a retiree to just barely meet the 4 per cent withdrawal scenario. That is why he and others consider the 4 per cent rule a safe withdrawal rate; it is a historical worst-case scenario, not an average.
2. The safe withdrawal rate has a 96 per cent probability of leaving more than 100 per cent of the original principal. (These are nominal returns, not inflation-adjusted returns, but still your original principal is almost all intact in historical dollars. This was startling to me).
3. The median value (50 per cent of the time) is 2.8 times the original principal. Thus, you have a high likelihood of having more money by the time you die, not running out of it.
4. There is only one time that the retiree runs out of money—in Year 31 of retirement.
So, despite the inherent flaws in the 4 per cent rule, Mr. Kitces is of the view that because historical safe withdrawal rates are not based on historical averages but rather on historical worst-case scenarios, the 4 per cent rule is more than an excellent rule of thumb.
This is an edited version of an article that was originally published for subscribers in the February 2021, issue of The Taxletter. You can profit from the award-winning advice subscribers receive regularly in The Taxletter.
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