Why You May Be Able To Retire Earlier Than You Think
Much of the research done on how much money can safely be withdrawn from retirement nest eggs focuses on an initial amount that is withdrawn in the first year of retirement and then assumes that this initial amount is increased by an inflationary factor every year thereafter. So what does this look like, and is it realistic? What does this practically mean for you as an investor?
Bengen’s 4% Rule
A widely accepted study on this topic that has received great attention was originally popularized by William Bengen in 1994. Bengen suggested that, with a portfolio consisting of half large-company stocks and half intermediate-term U.S. Treasury bonds, the maximum starting rate that one could safely withdraw was about 4%.
To arrive at this figure, he assumed that every year, the amount withdrawn would increase by an inflation factor, and that based on historical investment returns of the investment classes mentioned, a portfolio could withstand this type of withdrawal for at least 30 years. Today this is widely known as the 4% rule.
So, for example, if an investor’s total portfolio at retirement is $1,000,000, a 4% starting withdrawal rate will equate to $40,000 of income in year one. If year two is adjusted by a 3% inflation factor, the withdrawal in year two will increase to $41,200. This annual amount would continue to increase with inflation over a theoretical 30-year retirement time horizon.
Is This Even Necessary?
Bengen’s 4% rule has been challenged by many researchers. Some have argued that 4% is too high, while others have suggested that you can start with more than 4% if you apply certain rules during poor market conditions. However, the assumption of inflation adjustments is usually still present.
Despite the fact that the financial planning profession has generally accepted inflation adjustments when conducting retirement planning, there is a growing body of knowledge that this assumption may artificially overestimate how much an investor needs to maintain their desired lifestyle in retirement.
In my experience with helping clients with retirement planning over many years, it is rare that clients will request inflation adjustments from their investment income. This observation led me to write an article in 2005 for the Journal of Financial Planning on this topic, called “Reality Retirement Planning.”
In this article, I incorporated reduced spending data acquired from the Bureau of Labor Statistics into the retirement income planning process. Critics of this article suggested that the data used was not an accurate reflection of true spending reductions, and it could not be substantiated that the spending reductions were voluntary.
Since that article was published, additional research has been completed using updated data. One particular study was recently summarized in Investment News. The study was completed by the Employee Benefit Research Institute (EBRI), using data from 1992–2015; all numbers in the study were measured using 2015 dollars. The study found that households with under $200,000 in non-housing assets saw an asset drop of about 25% in their first 18 years of retirement. Retirees who had over $500,000 in non-housing assets to start with spent down an average of only 12% during their first 20 years of retirement. And roughly a third of retirees had more assets 20 years into retirement than they started retirement with. This new research, when coupled with past research, could imply that many retirees tend to spend less by choice rather than out of necessity.
Reduced Spending May Impact What You Need In Your Nest Egg
Reduced real spending needs in retirement can have significant implications as that applies to the size of the nest egg you need to maintain a desired lifestyle throughout retirement. This is especially significant when considering that some forms of retirement income may increase in retirement, including Social Security income and, in some cases, pension income. The increases in some forms of retirement income can help further alleviate pressure on retirement investment distributions.
To understand the demands that annual inflation adjustments have on a portfolio, it helps to revisit the hypothetical example above. Assuming an initial withdrawal of 4% on a $1,000,000 portfolio that is adjusted annually by a 3% inflation rate, the total amount of income withdrawn over a 30-year retirement would equal $1,903,017. If the annual inflation adjustments are excluded over the same 30-year period, the amount of income withdrawn would be $1,200,000, which would equal a $703,017 reduction in withdrawals.
If you use Bengen’s research and assume you will need to adjust your income upward every year throughout your retirement years, then you may plan on needing to either save more, spend less, retire later or pick up work during your retirement years. However, if you believe that your later years in retirement will be met by reduced real spending needs, similar to many clients I’ve worked with, you may be able to retire earlier than what traditional retirement planning would imply and/or spend more in your early, more active retirement years.
As with any type of financial planning, the actual real spending decrease, if any, can vary greatly between investors, and it is important to consider your unique circumstances before making bold decisions on your official retirement date.
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