The 4% Retirement Solution Revisited

I don’t like to be too repetitive. However, this question came up twice in a little over a week, so I thought it must be time to revisit the 4% solution. A hypothetical portfolio invested in 50% bonds and 50% stocks in 1946, subjected to a 4% withdrawal rate would have lasted for 53 years. The same portfolio subjected to a 5% withdrawal rate would last 34 years. Projecting an 8% withdrawal, mentioned in “I could be wrong now, but I don’t think so,” the portfolio lasted less than 16 years. This information comes from Richard C. Young’s Economic Analysis Report. Most of the usual sources including my Schwab account retirement calculator recommend the 4% solution. This calculator helpfully adds the probability of various balances at your projected death date. This calculator and others assume a 4% draw will give you something like a 90% probability of not outliving your money. Greater certainty would require more money.

Here, once again, is the basic calculation.

Start with your current total household income. Let’s say for the sake of this example, $100,000. Psychologists have discovered that in spite of protestations to the contrary, people spend more in retirement than they think they will. 80% is the current number favored by conventional wisdom. Only a few years ago this number was 75%.

So the amount of money you are likely to spend in retirement is:

$100,000 X 0.80 = $80,000

Some of us who live in high cost areas like suburban Washington, D.C. are in a position to move to a lower cost area, dropping our cost of living dramatically without lowering our quality of life. I plan to move to a state with low housing costs and low taxes like South Carolina. Almost everyone will spend less in retirement. There are no more daily commutes. This drops automobile expenses. Clothing costs drop now that white collars and suit jackets are only required for weddings and funerals.

So where is that money going to come from? $80,000 is the goal. First assume that you will be receiving Social Security. This number is provided by the Social Security Administration on an annual basis. I believe that any politician that attempts a bait and switch on Social Security will be burned alive by the Baby Boomers. There are too many of us and we vote. Gen X and Gen Y? Your Social Security may or may not be there when you need it. Plan accordingly.

For the sake of this example, let us assume Social Security in the amount of $25,000 a year for both husband and wife. Let us also assume that this hypothetical husband and wife also have a guaranteed pension of $30,000 a year. Unfortunately the folks with defined benefit pensions are becoming an endangered species.

So:

$80,000 - $25,000 - $30,000 = $25,000

This is the number you will have to generate every year (adjusted for inflation) for the rest of your life. To put things in perspective that is about the same as a job paying $12.50 an hour. To achieve this goal with a high probability of success, the economists and statisticians who study such things recommend the 4 percent solution.

Take the number not guaranteed by the Government or your employer and divide by 0.04.

Hence, in this example:

$25,000 ÷ 0.04 = $625,000

If you don’t like to divide, the same number can be calculated by multiplying your annual goal by 25.

In the past most of this money was expected to be generated by the increasing value of the single family home. It was assumed that real estate prices go up forever. 2008 proved this was a bad assumption. My generation was shocked by the sudden and dramatic drop in property values. Now savings and investments will be required to cover that shortfall. The basic calculation is pretty simple but achieving the goal is difficult. If you don’t plan on getting married, buying a house, or having children, it will be pretty easy to generate enough in your 401K to guarantee a comfortable retirement. However, if you want to have a life, things get harder. Don’t despair. Pick an investment strategy that is comfortable for you. There are several that are well proven. Then stick to the task with relentless determination. A disciplined approach, plus time, and the power of compound interest will take you where you want to go.