Retirement planning is certainly one of the most debated and important areas of financial planning. Each advisor and firm has a different approach when it comes to how they plan for retirement and how they help clients in retirement ensure that they have adequate income to last the rest of their lives. At its core, the components needed to plan for retirement are fairly clear: what are your guaranteed income sources during retirement and what are your variable sources? Similarly, what will your fixed expenses be and what will vary? Most retirees have social security, some have pension income, and most have financial portfolios from which they can take withdrawals over the course of several decades to complement those other income sources. That last point is our focus for today’s blog article: How much does one need to save and at what rate can one safely withdraw? Also, what is the ideal asset mix during those retirement years?
The March issue of Money Magazine goes into a fair amount of detail on the science behind systematic withdrawals (pulling money out of your financial portfolio each year to complement your fixed income sources). They comment on the famous “4% rule” which many advisors use as a rule of thumb. That theory basically holds that if you withdraw 4% of your portfolio starting around age 65, you’ll generally be able to take those withdrawals for life (+/- 30 years) without that portfolio running out of money. That rule assumes a roughly 50/50 mix of stocks to bonds and has worked during every 30 year period going back to 1926. Even a 4.5% withdrawal rate worked in nearly all (but not 100% of) 30-year periods.
However, this article features the opinions of Wade Pfau, a scholar on retirement income who shares his belief that both stocks and bonds (as overall asset classes) are expensive right now. He doesn’t think the markets are necessarily going to crash, but he thinks the current high valuation makes it more likely that normal returns over the coming years may be lower than what they have been in the past. That leads Pfau to recommending a portfolio draw down rate of 3% instead of 4%, a rate which he believes is more sustainable. Well, it’s great to be on the safe side, but 3% vs. 4% on a 1M portfolio is a drop of nearly $10,000 per year. Looking at it a different way, a client with 1M needs to save an extra $300,000 prior to retirement to generate the same $40,000 per year for life using the 3% rule. That is a big deal.
So what’s the big takeaway from this? Save more and spend less is the take away from almost every retirement planning article, and it certainly applies here. Beyond that, I wouldn’t think a 3% withdrawal rate is the new norm- I’m still advising my clients to withdraw at 4%. What I would recommend is being nimble and understanding that if asset classes do prove to be expensive and market returns disappoint going forward, have a plan to reduce that withdrawal rate without crushing your retirement dreams.
An alternate solution exists which in some ways challenges traditional financial planning advice: have a more equity-focused portfolio during retirement. Rather than 30/70 (stocks to bonds) consider 60/40 or even 70/30 during retirement. This recommendation isn’t just about taking on more risk with the hope of higher returns. It’s about considering what we’re seeing in the economy right now and having a smart asset allocation which adjusts to that. We are likely to be in a rising interest rate environment for the next decade or two and bond prices right now are at historical highs. One way to hedge against high bond prices and the risk of inflation is with a larger allocation to stocks. While taking on that additional equity risk may cause your portfolio some added volatility, many believe that step is necessary for those unwilling or unable to save dramatically more just before retirement.
The reality is that people will do their best and ultimately fit themselves into the financial mold which they create. If you can safely plan to have $70,000 per year in retirement, you will back yourself into the lifestyle which that number provides. As I’ve written about in the past, retirement should be less about dollars and cents and more about gaining a true understanding of how you enjoy spending your time. That understanding will lead to the most fulfilling retirement possible.
As always, feel free to e-mail me with any questions or concerns.
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This information is not intended to be a substitute for specific professional financial advice. Please note that individual situations can vary. Please see your financial professional regarding your specific situation.