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Concern about outliving one’s wealth is a major fear in the minds of Americans over 50 years old. Most retirees cannot re-enter the labor force under the same terms that they exited it, so their assets must constitute their lifetime income stream. And if they suffer poor returns early in their retirement, it means that their sustainable withdrawal rate will likely be sharply lower. Their standard of living will be more vulnerable to market volatility, and extra caution is warranted.

New research shows that Americans retiring in 2015 need to be far more conservative in their withdrawal rates during retirement. The historic 4% annual withdrawal rate is over two times the level that Americans can safely withdraw without expecting to outlive their assets. The real safe withdrawal rate, accounting for fees and today’s stock and bond market levels, is under 2% per year.

Because retirement income planning is still a relatively new field, views differ on sustainable withdrawal rates in retirement. William Bengen initiated the formal study in this area of “safe withdrawal rates” with an article he published in the Journal of Financial Planning in 1994. His research was a response to previous simplistic approaches that plugged fixed return assumptions into a spreadsheet—before, if a retiree assumed there would be a fixed return of 7% a year on retirement assets, then he or she could take 7% out safely without tapping into principal.

Bengen recognized it was naïve to use fixed returns such as those for calculations, as they masked significant underlying financial market volatility.
In the process, he uncovered the concept of “sequence of returns risk.” The average market return over a 30-year period might be quite generous, but if negative returns occur early—when the retirees have just started unwinding their assets for spending—then their safe lifetime income would be severely threatened.

At the time, Bengen considered 30 years to be a reasonably conservative planning horizon for a 65-year-old couple. He then looked at all the different rolling 30-year periods of financial market returns in the U.S. historical record since 1926 (for example, 1926-1955, 1927-1956 and so on, up to 1985-2014, the most recent period available).

For a hypothetical retiree beginning retirement at the start of each year, he tested what was the highest sustainable spending rate as a percentage of retirement date assets, adjusted for inflation and meant to last precisely 30 years. Using a 50% to 75% allocation to the S&P 500, and putting the remainder into intermediate-term government bonds, he found that the hypothetical retiree in 1966 could withdraw just over 4% of his or her retirement date assets and sustain this spending level over 30 years. That was the worst-case scenario from the U.S. historical record.

This was simplified, but the idea of the 4% rule took hold in the popular consciousness for advisors and consumers alike. It was a great way for advisors to frame the initial conversation.

But the 4% rule was really meant to be a simplification for research purposes. It includes a number of assumptions that do not reflect reality.

One is that international market data suggests the worst-case scenario would be worse than that seen in U.S. history and we overestimate future U.S.
returns. Another is that the combined unprecedented low interest rate and high stock market valuation levels facing today’s retirees are extremely rare in the U.S. historical record. This leads to much lower returns over the following 10 years, when millions of baby boomers will leave the work force.

Nor does the 4% rule take into account other factors, such as investment fees, which need to be accounted for in any analysis. And as people live longer, 30 years is no longer a conservative planning horizon for 65-year-old couples.

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