Retirees face a significant challenge of determining how much they can spend on a weekly or yearly basis. The fear of running out of money is commonly referred to as superannuation, which is one of the primary concerns for most retirees. This issue is a more significant concern today than in the past due to the decrease in pensions and the rise of defined contribution account type plans.
There are two common approaches that help to prevent outliving one's money including the 4 percent per year approach and money-for-life (Bucket) approach.
4 percent per year approach:
The 4% withdrawal rate is a well-known rule of thumb in retirement planning. It was first introduced by financial advisor William Bengen in 1994 and suggests that retirees can withdraw 4% of their retirement savings in the first year of retirement. After that, they can adjust the amount for inflation in subsequent years to create an income stream that will last at least 30 years. His assumptions at the time factored that you could only invest in 3 things: an S&P 500 fund, an intermediate government corporate bond fund, and T-bills. A couple years later he realized that wasn’t what he did with his clients as he included small cap stock in the investment portfolio. So he redid his analysis adjusting for small cap composition. He determined by adding small cap funds and you always want to get a raise for inflation and you always want to make the money last for 30 years you could use a 4.5 percent withdraw rate.
This approach is relatively simple to implement and conceptually easy to understand. It involves distributing four percent of the capital balance each year and typically has a high success rate, especially when invested in a balanced portfolio. For instance, a portfolio with 60 percent equities and 40 percent fixed income will generally offer a good balance between income, growth, and downside protection. However, one potential risk for retirees is when the retirement portfolio experiences several years of large losses combined with distributions of four percent or more of the portfolio. Therefore, some advisors and clients may opt to use the 3 percent model instead.
To maintain a withdrawal rate of four percent, it is recommended to have an account balance of 25 times the required income. This means that an earning rate of only 1.310 percent would suffice for a 30-year payout, assuming no inflation or annuity due payments. However, if the withdrawal rate is adjusted for inflation at a rate of three percent, then an earning rate of 4.349 percent per annum will be necessary for the same period.
It's important to note that the safety of a 4% initial withdrawal strategy depends on the assumptions made about asset returns. If we use historical averages to simulate failure rates for retirees who are spending an inflation-adjusted 4% of their retirement date assets over 30 years, the estimated failure rate would be around 6%. However, this projected failure rate could increase significantly if real returns decline. Here is a link to a more detailed paper talking about the safety of a 4% withdraw rate in a low -yield world. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2201323
Here is an chart with varying withdraw rates from 3 percent up to 8 percent per year. It provides earning rates adjusted for inflation and portfolio allocation.
Bucket approach:
This strategy involves dividing your assets into six five-year tranches and funding each of them with the right investment choices and sufficient money to provide retirement income for that period. The chart below provides an example that shows the percentage of capital required in each tranche, the expected investment return needed for that tranche, and the type of asset class essential to sustain this return.
This investment strategy aims to generate a return of five to six percent overall. Its objective is to replenish the initial income every five years. It's worth noting that this method is not a significant deviation from traditional asset management practices.
