To figure out how much you need for retirement, you need to know how much you can reasonably distribute from your retirement portfolio each year. In the world of finance, we’ve been operating under something called the “4 percent rule” for the last 20 years or so. This rule basically says that if you distribute 4 percent of your portfolio in your first year of retirement and adjust that number up each year for inflation, you run a low likelihood of depleting your funds over a typical 30-year retirement.
For instance, if you have $1 million in your portfolio when you retire, you’d distribute $40,000 your first year. If inflation were 3 percent next year, you’d distribute $41,200 and so on each year. The original research on retirement distributions was published in 1994 by Bill Bengen in the Journal of Financial Planning. Mr. Bengen’s research demonstrated that historically, at a 4 percent initial withdrawal rate adjusted for inflation annually, investors would have run a low probability of depleting an account prior to the end of 30 years. As you increased initial distributions to 5 percent, 6 percent and above, the portfolio failure rates rose rapidly. So, if you wanted a fairly high assurance that you wouldn’t run out of money, you had to be prepared to live off 4 percent.
Even though Bengen’s original research did not include the stock market debacle of the 2000s, it is still informative today, because it included the 80 percent stock market declines from the Great Depression and the roughly 50 percent decline in the 1970s along with the inflationary cycle that accompanied it.
Regardless of the historical data, investors may still wonder if the 4 percent guideline is a prudent benchmark for today. To get some insight into this question, we examined specific historical cycles to see what caused portfolios to suffer depletions of their assets at different distribution rates.
Based on our internal research on portfolio distribution rates, we see that many of the hypothetical portfolio failures occur for retirements starting during the late 1960s and 1970s, when bear markets were coupled with high inflation. When we dug deeper, we saw that high, sustained inflation was the real culprit.
Let’s assume you retired in 1965, with $1 million and a goal of a $50,000 per year inflation adjusted distribution (5 percent initial rate). Between 1965 and the end of 1984, inflation ran at 6.3 percent per year. By the end of 1984, your portfolio would have needed to distribute about $168,000 to buy the same goods and services that you could have bought 20 years earlier with $50,000. Consequently, your distribution rate at the end of that 20-year period would have been about 17 percent of the original $1 million you retired with ($168,000 / $1 million). And by the end of 1994 (which would have been the end of the 30-year cycle), inflation would have pushed your annual distribution to about $230,000, or 23 percent of your original portfolio value.
Moreover, the cumulative inflation-adjusted distributions that the initial $1 million portfolio would have had to produce over those 30 years if you started at a 5 percent withdrawal of $50,000 was about $3.8 million. Using a balanced 60 percent stock and 40 percent bond model, this portfolio simulation failed in the mid-1980s, and you can see why – the annual distribution amounts were driven too high because of inflation.
Our conclusion is that it’s not necessarily a bear market that poses the most risk to retired investors. It’s the inflation rate applied to the initial distribution amount. If inflation is low (below 3 percent) during your first 15 years of retirement, the odds of making it at a 4 percent distribution are pretty good. If inflation is high, the odds decline.
Consider that if you had no inflation, got a 0 percent return on your money each year, and distributed 4 percent of your original starting value per year, your money would last about 25 years. To last 30 years under these same assumptions, you only need a 1.35 percent average annualized return if you have no inflation. The bottom line is that in a low inflation environment, you don’t need big returns to make the numbers work. But as inflation rises, so does your required rate of return.
While the 4 percent guideline is certainly no guarantee, it’s still a reasonable guideline for retired investors in today’s markets. But if inflation kicks up for more than a few years, then we’re dealing with a different set of probabilities.
Calculations for various retirement cycles and portfolio failure and success rates were performed by Northstar Investment Advisors, LLC. Errors in data calculation, interpretation and transmission can and do occur, and thus above material should be treated solely as informational, and we make no representation as to its accuracy. Above material is for information and education purposes only, and does not take into account individual circumstances.