Wednesday, March 9, 2011

What is 'The Four Percent Solution'?

In the book, 'A Safe Retirement : The 4 Keys to a Safe Retirement'  I discuss ways in which you can determine how much money you will need on an annual basis during retirement. However, it is also fundamental to look at this important question from the opposing end. How much money are you allowed to spend without running out before you reach the pearly gates?
Of equal interest is how much are you allowed to spend and not build up an enormous surplus that you’re not able to enjoy yourselves?
Much thought has gone into these questions and into finding the exact sweet spot of allowing the highest possible income with microscopic risk of outliving your money.
            Here I’ll cover one such formula that has become a recent topic of debate and interest among people looking for that “magic” rate of withdrawal.  In my research with retirees, over and over I hear how people are animate about not touching the principal that generates their retirement income.  Certainly, this should be a goal and is critical to you staying on track with your plan as we’ll soon discuss.
            But is there a way in which people can take income and still ensure that their principal will remain constant?  Certainly we can buy CDs or original issue bonds (and hold until maturity) for this to occur.  However, the reality is that this approach not only yields low rates on CDs and it’s very difficult to gain a bond at the exact value that you’ll be able to redeem it at without fluctuations in price over this time.  Plus for most of us, our investment portfolio will be the major source of retirement income and that portfolio should be made of various holdings and asset classes (stocks, bonds, mutual funds, etc.) 
            So the question becomes ‘how much should I withdraw from my portfolio to gain an income while ensuring protection of my principal?’: 7%?  5%?  This is an interesting question when you’re seeking a percentage rather than an amount.  Even with a large portfolio, if you look at percentages rather than amounts for your yearly income, a single percentage change can impact your ability to maintain your principal.
            So, what is the right number?
            Fortunately we have professors, analysts and economists who are much smarter than me who study this stuff.  I'll discuss one approach that is gaining interest and attention: the 4% solution.  This is an approach that says that withdrawing 4% from your investments will provide lifetime income and you’ll never outlive your assets. 
           
     The Trinity Study -
            In 1998 a group of finance professors at Trinity University in San Antonio, Texas published a paper studying the optimal percentage annual withdrawal from a retirement portfolio. They based their study on various portfolio asset allocation compositions between stocks and bonds. (I discuss asset allocation more in the following chapter, How to Maintain Your Retirement.) They considered the following portfolios where stocks are the S&P 500 and bonds are high-grade and from the United States:

  •  100% stocks
  •  100% bonds
  • 25% stocks, 75% bonds
  • 50% each of stocks and bonds
  • 75% stocks, 25% bonds
The interesting part of the study was that in any of the asset mixes, a withdrawal rate of 4% protected 100% of your principal.  What is also interesting is that a conservative mix of 25% stick and 75% bonds would allow for protection of principal and the ability to withdraw 6% of your portfolio.

            Below is a link to a chart from the study showing the decline in the portfolios over thirty years.
           
            However, to fully recognize the viability of this study in an individual’s portfolio as a driver of income, it’s necessary to consider and include inflation into the mix.  The more appropriate chart is provided below which takes into consideration yearly inflation and when this is included the 4% figure becomes even more pronounced.

Source: Sustainable Withdrawal Rates From Your Retirement Portfolio Philip L. Cooley,Carl M. Hubbard2 and Daniel T. Walz


    The numbers in the main body of the chart refer to the percentage likelihood of reaching the goal of not running out of retirement funds. When inflation is included (and it must be to be valid), we see that the greatest likelihood of not having to tap into principal occurs with a portfolio of 75% stocks and 25% bonds.
    Taken in the wrong light, this graph can be unsettling for the conservative retiree. Should you have your entire portfolio in stocks through good times and bad or you’ll end up in the street? No, but if you’re looking at a 30 time horizon and are not interested in tapping into your principal, you’ll need more stocks than perhaps would be recommended for the retired investor. And by stocks I don’t mean those selling for two cents a share and promising 1000% return in just a few short days. I mean a highly diversified portfolio of blue chip companies.
    The following are the conclusions from the study as pointed out from the online wiki on the study:
“The study produced a number of conclusions, including:


  • Withdrawal periods longer than 15 years dramatically reduced the probability of success at withdrawal rates exceeding five percent. 
  • Bonds increase the success rate for lower to mid level withdrawal rates, but most retirees would benefit with at least a 50 percent allocation to stocks. 
  • Retirees who desire inflation-adjusted withdrawals must anticipate a substantially reduced withdrawal rate from the initial portfolio. 
  • Stock-dominated portfolios using a 3 to 4 percent withdrawal rate may create rich heirs at the expense of the retiree's current standard of living. 
  • For a payout of 15 years or less, a withdrawal rate of 8 to 9 percent from a stock-dominated portfolio appears sustainable.”


    The Trinity Study actually found that a heavily stock laden portfolio of $100,000—tapped at 4% over thirty years, and assuming the rate was not adjusted for inflation—created a $700,000 portfolio at the end of the time frame. Wow. But based on historic market returns this is absolutely feasible.
    I think for most retirees and those considering retirement there is value in evaluating the 4% solution.  When the study “backtracked” with historic data, the numbers in the chart bare out the following comment:

“One scenario backtested in the Trinity study suggests that a retiree with a suitably allocated $1 million portfolio could withdraw $40,000 the first year, give herself a cost-of-living adjustment every year afterwards, and have a 98% chance of the portfolio lasting at least 30 years.” 

Sharpe’s Point - 
            Now before you run out and decide that the 4% solution is what you’re going to do, understand that it isn’t without debate. Nobel Prize winner William Sharpe (creator of the ‘Sharpe Ratio’) disagreed somewhat with the findings of the Trinity Study. He felt it was too rigid and risked building up an unspent surplus. If the goal is to leave a significant inheritance that’s one thing, but if, instead, maximizing the potential of a retirement portfolio is what’s wanted then 4% might not be the best avenue.
            He also cautioned that the solution would encourage fixed spending habits that can prove problematic in down markets.
            “’If a retiree adopts a 4% rule, he will waste money by purchasing surpluses, will overpay for his spending distribution, and may be saddled with an inferior spending plan,’ wrote Sharpe and colleagues Jason Scott, managing director of the Retiree Research Center at Financial Engines, and John Watson, a fellow at Financial Engines.”
            Sharpe’s idea then was that the real solution was regular monitoring and tailoring of the portfolio to find the optimal amount.
I couldn’t agree more, and it’s important to evaluate all of the information on this approach (we include web links to the content mentioned here and other resources for your research in the Resources Area).  If you work with an advisor ask them about this approach.  When looking at the research, it seems that 4% is a great place to start but this doesn’t mean that we can neglect the ongoing and important questions that only you, as the investor, must answer.
What’s the anticipated time horizon of the portfolio? The longer the anticipated lifespan, the lower the percentage withdrawal. It’s common sense. If you’re looking at thirty years or more, 3% might be a better figure.
In contrast, if you’re retiring older, and perhaps not in good health, a shorter lifespan can be factored in and therefore a larger percentage of the funds can be spent each year. Although, again, not written in stone, with an anticipated payout period of fifteen years or less, 8% or so could be tested as a permissible withdrawal rate.

Prudence and the Annual Review -
            It would appear the best course of action, as is so often the case, is to take these studies for what they are; guidelines. Considering a 4% annual withdrawal rate is an excellent starting point.
            Review the math yourself, or with your Financial Advisor if that’s your case, and see if it works for your situation.
Be prudent.
If timing the synchronicity of the end of the lifespans of both yourself and your portfolio isn’t exactly possible (is it ever?) then which is the worse evil; running out of money or leaving a bit extra for your loved ones? I know my answer.
The authors of the Trinity Study wrote:
“The word planning is emphasized because of the great uncertainties in the stock and bond markets. Mid-course corrections likely will be required, with the actual dollar amounts withdrawn adjusted downward or upward relative to the plan. The investor needs to keep in mind that selection of a withdrawal rate is not a matter of contract but rather a matter of planning.”

            Planning and regular reassessments are indeed the additional aspects to rounding out the 4% solution.
            I cover the importance of the annual review in more depth in my book, 'A Safe Retirement ; The 4 Keys to a Safe Retirement', but understand that regular reviews of your portfolio and overall retirement lifestyle needs are a key aspect to maintaining your Safe Retirement. Approach your annual budget from the aspect of how much can you spend. Start with 4% and see where it takes you; many financial planners report using this number with success. And then reassess each year at your designated annual review to make sure this number is still working for you.            
            Prudence is a lovely lady, make sure she’s part of your Safe Retirement and you’ll be living your dream for the rest of your lives. 

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