For most Americans, these funds are usually in qualified plan investments such as IRAs, 401(k) plans and 403(b) plans. Twenty years ago, William P. Bengen, a fee-only financial planner, determined that a client with a $1 million portfolio split 50/50 between stocks and bonds could live at least 30 years with a 4% annual withdrawal rate on the retirement portfolio balance. But with the market turbulence in the last decade and the current low interest rates, experts are challenging this 4% rule of thumb. And so should you.
In the last few months, there have been a couple of noteworthy research papers on this topic. One is from JP Morgan and another is from Texas Tech Professor Michael Finke, Ph.D., CFP®. (I have mentioned Texas Tech financial planning professors in the past. Tech seems to be a hotbed of useful research.)
These two research papers challenge the traditional rules of thumb. The 4% rule of thumb works to protect purchasing power in the face of inflation. A second rule of thumb, the required minimum distribution approach, originates from the IRS and bases the withdrawals on life expectancy. Instead, these researchers encourage a better approach to looking at retirement income from your pool of assets.
Michael Finke’s paper warns of the dangers of relying on the 4% rule during today’s low interest rate environment.
The JP Morgan paper concludes that the 4% rule and the required minimum distribution method do not address the highly personalized aspects of your retirement withdrawals. From the 2008 financial crisis through today, following these rules of thumb risk early depletion of retirement funds and the chance that you cannot maintain your desired lifestyle throughout retirement. It is time to reconsider how to calculate withdrawals from your retirement assets. The JP Morgan Dynamic Model method uses the following five factors.
Factor 1: Your preference for size and timing of withdrawal — “Retirees get less satisfaction from each additional dollar of income withdrawn above a certain point. … [It is human behavior that] income received today is more attractive than income received in the future… this time preference for earlier income is strictly emotional in nature.”
Factor 2: Your level of wealth and lifetime income — “… the downside risk is greater for those with less initial wealth and lower or no lifetime income, relative to those with greater wealth and higher levels of lifetime income.”
Factor 3: Your current age and life expectancy — “A retiree’s probability of survival decreases as age increases… the utility value of a dollar spent later is significantly less than that of a dollar spent at a younger age, simply because there are greater odds the later dollar will never actually be used.”
Factor 4: The investment market randomness and extreme events — Consider “how different withdrawal strategies might fare in a [wide] variety of economic and financial market environments.”
Factor 5: The dynamic nature of your decision-making process “It is possible to broadly estimate living, travel and health care expenses but each of these also closely depends on unknown factors such as inflation, travel frequency and destinations, and general retiree well-being and related heath care needs. Similarly, portfolio performance will depend on future economic and financial market performance which is completely unknowable in the present.”
One of our local financial advisors, Wm. Jene Tebeaux, CFP®, CFA®, CAIA®, CEO of Paragon Financial Advisors, has been helping his clients with dynamic models of withdrawal rates for many years. When I asked him about the 4% rule of thumb model versus the JP Morgan Dynamic Model, he provided this insight.
I completely agree that the withdrawal rate from qualified plans should consider an individual’s circumstances rather than a “formulaic,” specified withdrawal rate. If an individual has other sources of fixed income (pensions, social security, etc.) and/or more limited expense needs, why withdraw from qualified funds at a 4% rate? Early withdrawals will trigger income taxes on the amount withdrawn and lose the tax deferred earnings — on both the amount of tax and the re-investable portion of the after-tax withdrawal amount. Required minimum distributions from IRAs don’t reach the 4% level until age 73. The only reason for earlier withdrawals might be a higher future income tax rate for the individual if withdrawals are deferred.
The rules of thumb are easy to apply in a do-it-yourself situation. Unfortunately, they will probably not get you where you want to be in your retirement years. They will not get you to a financially secure lifetime and the relief of anxiety about outliving your money. These days you need a customized dynamic approach to retirement withdrawals.