More Rules for Retirees

The decision as to when to retire and how much to draw from savings and investments is a large looming part of my life. I have read so much on the subject I am growing tired of the whole business. The traditional 4% rule of thumb was first proposed by William Bengen in a landmark article published in the Journal of Financial Planning in 1994. Since then numerous authors have tweaked this number up or down or suggested methods of adjusting a hard and fast rule to the realities of current market conditions. The long and the short of all these statistical analyses are; the more optimistic advisors say 5% is OK; the pessimists say, “Nah, your better off at 3%.”

All the following discussions assume a portfolio of 60% stocks and 40% bonds.

In an article entitled, How to Inflation-Adjust Your Retirement-Portfolio Withdrawls, Christine Benz reports on a new method based on the 4% rule. Let us imagine a retirement portfolio valued at $1,000,000. In the first year, the retiree is allowed to withdrawal 4% or $40,000. Simple enough, but how to adjust for inflation in the second year? The author proposes adding a percentage based on the Consumer Price Index. Hence if inflation in the first year of this example was running at 4%, the retiree would withdrawal $40,000 + 0.04 ($40,000) or $41,600.

I see a lot of problems with this method. It is assuming that the market moves with inflation. How about the stagflation of the 1970s, years when the market was flat and inflation was running wild? In such a situation this method would wipe out that $1,000,000 nest egg in short order. In boom years with relatively low inflation, say 1985 to 1999, the retirees could find themselves living on dog food, so their heirs could buy SUVs and vacation condos.

Benz notes, “Others, such as financial expert Michael Kitces, have argued in favor of a flexible withdrawal rate that takes market valuations into account.”

http://www.kitces.com/assets/pdfs/May_2008_Kitces_Report.pdf

Read this article when you have the time. It is long and somewhat arcane but it will give you a lot to think about (as if I need that). Here are his key findings.

Kitces believes that the withdrawal rate should be keyed to the Market’s Price Earnings Ratio (P/E). If the P/E ratio is over 20, history indicates that the market is overvalued. In such circumstance the author recommends not exceeding a 4.5% base rate for withdrawals. If the P/E ratio is between 12 and 20, the historic norm, Kitces believes the retiree can safely bump their withdrawal rate to 5%. If the P/E ratio is below 12%, history indicates the market is about to experience a significant increase. In such a situation a retiree could safely withdraw 5.5%.

By the way, at the time the article was written, May 2008, the P/E ratio for the S&P was 24.2. History has proven Kitces’s proposal was correct, at least in this instance. The market was wildly overvalued. In October of that year, it fell from the sky like a wounded duck.