The traditional 4 percent rule for retirement savings withdrawals can lead to disaster, said Ilene Davis, founder and owner of Financial Independence Services in Cocoa, Fla.
Whether a withdrawal plan can succeed through a long retirement depends on the assumptions that are made in the beginning, and many advisors are using the wrong assumptions, Davis said in a recent interview.
Davis, who has operated her own practice since 1986, has degrees in math and accounting and is a CFP, which she said gives her a different view of finances. She serves mostly middle-income clients but says she will help anyone who agrees to save $100 a month.
“While I am aware the 4 percent initial withdrawal is a rule of thumb, my concern is that advisors focus on past performance and assume annual withdrawal rate increases based on the prior year's consumer price index, which could differ significantly from retirees' real lifestyle and needs,” she said.
Clients forget they have to pay taxes on some Social Security income, she added. A realistic inflation rate has to be included in the calculations, as well as realistic rates of return on investments. Instead, retirement plans are often based on predicted inflation rates that are too low and return rates that are too high, she said.
“If advisors are using a retirement plan tool and they do not know what assumptions it is based on, they are opening themselves up for lawsuits,” Davis said. “It also could mean disaster for the client and it could destroy the country” when large numbers of people do not have enough retirement money to live on.
Davis gave the following example of how a 1 percent difference in an assumption that is built into a retirement tool can make a vast difference in what is needed in savings.
Joe is 45 and wants to retire in 20 years. He expects to live another 30 years after that. He wants an income equivalent to $40,000 in current dollars through retirement and assumes his investments net of taxes will earn 5 percent a year.
Assuming inflation averages 3 percent a year, $72,244 would be needed in 20 years to have the same buying power as his current $40,000, so that is the amount he would need to be able to withdraw in the first year of his retirement. This would require an investment of about $1,663,000 at retirement.
If the inflation rate is assumed to be 4 percent a year, his $40,000 lifestyle would require $87,645 in 20 years and an investment of approximately $2,297,000.