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Planning for retirement is probably the single most significant challenge that an investor will face. After spending a career accumulating sufficient assets, individuals are suddenly thrust to the back-end of the process: taking distributions. Retirees face the twin challenges of covering expenses and not depleting savings too quickly. A misstep could mean having insufficient funds to see them through retirement.
Historically, the retirement planning process has comprised of two completely separate phases: accumulation during
the working years and distribution once in retirement. Though financial consultants followed a logical and straight-forward process to determine retirement needs, the traditional process placed an extraordinary amount of pressure on choosing the right withdrawal rate
The 4-Percent Solution
For about the past two decades, financial consultants have hung their hats on a distribution rate of 4 percent. In a study published by William Bengen nearly 20 years ago and using historical data dating back to 1926, this pace was determined as a safe distribution rate for a portfolio divided equally between large cap stocks and bonds in virtually any type of economic environment. More recently, however, the accuracy of this solution has come under increased scrutiny.
To understand the shortfalls of the 4-percent rule, consider two investors on the cusp of retirement in 2008, each with $1 million saved at the beginning of the year. The first investor retires at the beginning of 2008, and using the 4-percent standard, withdraws $40,000 annually throughout her retirement. The second investor postpones retirement until the end of 2008. Over the course of the year, however, his $1 million portfolio takes a hit and declines to $700,000. Applying the 4-percent rule, this investor would receive a distribution of $28,000 per year during retirement.
Despite achieving the same savings goal by early 2008, market conditions and timing made a $12,000 per year difference in retirement incomes. What the 4-percent approach doesn’t consider is market performance during the distribution phase, not just
An Integrated Approach
A new approach that considers market performance history during both the accumulation and distribution phases can help investors plan better for retirement. A recent study conducted by Wade Pfau, who holds a doctorate in economics from Princeton University, uses data stretching back to 1870 and suggests that evaluating historical simulations that include accumulation and distribution phases can provide a more accurate prediction of a sustainable distribution rate.
As a result of Pfau’s research, financial consultants are doing a couple of things differently. First, consultants are taking the cyclicality of the markets into greater account. Historical data shows that the lowest maximum distribution rates (the most an investor could withdraw safely without running out of money) tend to occur after prolonged bull markets. For investors facing retirement following such market environments, establishing a lower distribution rate may help portfolios withstand potentially challenging markets ahead.
Conversely, prolonged bear markets during the wealth accumulation phase tend to allow for higher maximum withdrawal rates. For those retiring at the end of a challenging period, it may be possible to establish a higher distribution rate in anticipation of stronger markets ahead. For instance, investors retiring at the end of the 1970s could have used a distribution rate exceeding 6 percent over 30 years without running out of money. Of course, these bull and bear market relationships are not perfectly predictable.
Along with market cyclicality, consultants are also revisiting at which rate investors are saving for retirement. It is still critical to begin the planning process with an estimate of the withdrawals needed from a pool of assets to cover expenses. Now, however, the second step is to focus on establishing a sufficient savings rate.
By focusing on the savings rate, investors are concentrating on a planning element they can control. Plus, with consistent savings over time, there may be less reliance on market performance during the final years of accumulation. According to Phau’s data, an investor planning to work for 30 years and desiring to replace 50 percent of her working income from retirement assets should be successful in nearly any economic environment by dedicating 16.62 percent of her income annually to retirement savings.
Giving Investors More Control
Clearly, many other variables and assumptions factor into a retirement plan, including life expectancy, asset allocation, inflation, etc. It’s certainly not an exact science. However, by integrating market return assumptions during both the accumulation and distribution phases of an investor’s life, it is possible to determine more accurately what investors can control—the amount of money to save now to ensure obligations are met during retirement.