Rethinking Retirement Financial Planning

Disclaimer: The intended audience for this article is someone who is reasonably savvy on financial planning. If you’re a novice, stop reading now and just do whatever your financial planner tells you to do.

The conventional advice for financial planning in retirement has generally been the 4% rule. Ie, on the day of your retirement, you compute what 4% of your portfolio comes out to. And then you withdraw exactly this amount, adjusted for inflation, every single year for the rest of your life.

Ironically enough, such a rule is simultaneously too conservative, and too risky. To understand why, we need to look at how this rule first arose:

The rule was created in 1993 by Bill Bengen … examined every 30-year retirement period since 1926, reconstructing market conditions and inflation. He identified 1969 as the worst year for retirees because a combination of low returns and high inflation had eroded the value of savings. Using that as his worst case, Mr. Bengen tested different withdrawal percentages to see which one would allow savings to last 30 years. At first 4 percent worked, he says, based on a portfolio with a 60/40 split between large-cap stocks and intermediate-term government bonds

From the above, we can immediately see a couple ways in which the 4% rule is flawed at its foundations. In some ways too optimistic, and in other ways, too pessimistic.

First, let’s look at the ways in which the 4% rule is too optimistic:

Age – The rule assumes that your retirement will last only 30 years at most. Ie, if you retire at 62, then you will die before you turn 92. This might be true for most people, but we all know of people who have lived long past that. Especially given modern advances in medicine. Do you really want to risk ending up penniless at the age of 92?

Historical data – The rule was constructed by looking backwards at historical stock and bond returns, from 1926 to 1993. The assumption is that stock and bond returns in the future will match historical stock and bond returns. Such an assumption is shaky at best, and completely broken at worst. We are living in a world of ultra-low interest rates and low GDP growth rates. Institutions like Vanguard are projecting real returns of ~4% for stocks, and the inflation-adjusted SEC yield on bonds is less than 1%. There is little reason to believe that future returns will match past returns.


And then the ways in which it is too pessimistic:

Worst possible outcome – The rule was devised by looking at the worst possible outcome that could have occurred between 1926 and 1993 in USA. First, let’s acknowledge that the future is always capable of never-before-seen surprises – worse than anything seen thus far. But let’s also acknowledge that this worst-possible-outcome will never happen to the vast majority of people. This means that most of us are leaving a lot of money on the table… in fear of a catastrophe that we’re not adequately prepared for anyway.

60/40 portfolio – The 4% rule assumes a 60/40 stock-bond portfolio. This may be fine for most retirees. But if you’re someone with greater risk tolerance and are willing to invest a greater percentage in stocks, the 4% withdrawal rate would be too pessimistic for your case. Particularly if you’re willing to invest in overseas markets where returns are much higher.


And finally, consider the ways in which the rule is just flawed … period:

No mechanism for self-correction – The most stable systems are capable of self-correction, in order to maintain stability. Consider the human body – when it gets too hot, your body will slow down its metabolism and start sweating, in order to cool itself down. Conversely, when it gets too hot, your body will rev up its metabolism and begin shivering, in order to generate more heat.

The 4% rule does not offer any means of self-correction. Once it starts down a path, you’re buckled in for the ride with no accelerator or brakes. If you start off too stingy, you will perpetually be too stingy. If you start off too bold, you will find yourself bankrupt before long.

Catastrophic loss – Which brings us to the biggest problem of all. The risk of catastrophic failure. This isn’t just fancy wordplay – loss occurs when you find yourself in a shortfall, whereas a catastrophic loss occurs when you lose absolutely everything and find yourself penniless. Because the 4% rule does not allow for any self-correction, it leaves you vulnerable to sudden catastrophic loss. One day, you’re living fine with a $40,000/year income. And the next, you’re completely broke, living off your meagre social security payouts.

I think there’s a better way to do retirement planning. A way that avoids the pitfalls above.

Flexible Budgeting

Of my 3 suggestions, this would be the most important. Many of the problems with the 4% rule, arise because you’re withdrawing a fixed dollar amount every year, regardless of whether your portfolio is booming or tanking. This is absolutely ridiculous as a principle. If you get a 30% raise at work, would you really deny yourself a little extra money for traveling and eating out? If you were laid off from your job, would you still insist on traveling internationally for leisure? 

Of course not. We adjust our budgets every year to match our income, and retirement should be no different.

Instead of withdrawing the exact same amount of money every year, we should instead draw up a new budget every year, or every few years, based on the latest value of our retirement portfolio. If your portfolio has crashed by 30%, you should tighten your belt and withdraw less money. And if your portfolio surges by 30%, allow yourself some additional leeway to do the things you want to do. This is exactly the self-correction mechanism that we had discussed earlier.

Here’s something really cool – as long as you are diversified and withdraw a consistent percentage of your portfolio every single year, you are mathematically guaranteed to never go bankrupt. Never. Even if the markets enter a prolonged recession. No matter how long you remain alive. This is a guarantee that even the 4% rule cannot make.

On the flip side, you can utilize this additional security to stop being paranoid, and take reasonable risks. For example, if your portfolio is projected to produce real returns of 6%, you can then withdraw 6% of your latest portfolio value, at the start of every year, for the duration of your entire retirement.

Because your portfolio value will experience up-and-downs, your yearly income will also experience fluctuations. But on average, you will get to spend more money, while still being guaranteed that you’ll never go bankrupt. That is truly a win-win solution we need.

Forward-Looking Returns Projections

We had earlier talked about the problems with using historical data to predict future financial returns. Ie, is it safe to assume 6% annual returns, just because we’ve achieved 6% returns in the past? I think this is a very risky assumption to make, and one that we should avoid.

But how else would we go about predicting our future returns? The first key insight here is that our portfolio returns depend tremendously on the composition of our portfolio. The idea that all portfolios should plan for a single rate of return like 4%, is ridiculous. The more stocks your portfolio contains, the greater your expected return (and risk) should be.

Based on this, you can decide how much of your portfolio you want to invest in stocks as opposed to bonds. The more risk you’re willing to take, the more you should invest in stocks, the greater returns you can expect, and the more money you’ll be able to withdraw from your portfolio every year.

This begs the following question: how do we estimate the expected returns for stocks and bonds? 

The answer for bonds is simple enough. Every bond and bond-fund has a SEC-yield listed, and that makes for an excellent estimate of the (nominal) yearly returns you can expect from that bond. You can then subtract from it the inflation rate, in order to get the real yearly returns.

The answer for stocks is more complex. People have mostly estimated stock returns using historical data, but this is foolhardy because today’s market conditions are very different from decades past. Instead, I would recommend using estimates provided by your most trusted source. For example, Warren Buffett has publicly predicted 6-7% nominal returns in the stock market. And Vanguard has predicted under 4% real returns for the S&P 500. Personally, I have developed my own model for predicting stock market returns, (I’ve written more about it here) but you’re better off using estimates from a more widely credited source.

Whatever source you decide to trust, you can then combine these different projections along with your specific portfolio composition, in order to better estimate your overall returns. For example, suppose your portfolio looks like the following:

  1. 30% in bonds (BND)
    1. Projected real annual returns of 1%
  2. 30% in S&P 500 Index (VOO)
    1. Projected real annual returns of 5%
  3. 20% in MSCI EAFE index (VEA)
    1. Projected real annual returns of 7%
  4. 20% in Emerging Markets index (VWO)
    1. Projected real annual returns of 9%

Using the above numbers, you would then project your overall portfolio’s real annual returns to be:

(0.30 * 1) + (0.30 * 5) + (0.20 * 7) + (0.20 * 9) = 5%

Based on the above, as long as you reassess your portfolio value at the start of every year, and only withdraw 5% of that amount, you will have yourself a retirement income that is relatively stable across the decades, and completely immune to bankruptcy.

Better Global Diversification

You can see that in my example calculation above, I had projected the S&P 500’s real returns to be a measly 5%. There are 2 main reasons for this.

First, the earnings yield for the S&P 500 today is significantly lower than in past decades.

Second, as a mature and developed economy, America’s real GDP growth rate is also significantly lower than in past decades.

Combine both of these factors, and we can see why the expected returns for today’s S&P 500 are so much lower than in the past. Vanguard agrees as well, and is even more pessimistic than I am. They are estimating inflation-adjusted returns to be under 4%.

However, this isn’t something we have to live with. Looking outside the S&P 500, there are plenty of other markets offering attractive returns.

First, let’s look at the index of other developed nations, such as Britain, Germany and Japan. Their GDP growth rate might be comparable or slightly lower than America’s. However, their earnings yield is significantly higher. Hence why both Vanguard and my model are predicting ~7% real returns for the MSCI EAFE index. Considering that these are developed countries similar to America, such investments would also be equally safe. There is little reason to pass them up.

Second, let’s look at Emerging Markets, such as China and India. Not only is their earnings yield higher, but their real GDP growth rate is significantly higher as well. Hence why my model predicts ~9% real returns for the FTSE Emerging Markets index. Admittedly investing in Emerging Markets carries more risk. But given the substantial difference in returns, it is worth investing at least some of your portfolio here. As the famous saying goes, diversification is the only free lunch.

If one were to invest only in the S&P 500 and bonds, I would recommend planning for real returns far under 4%. But by investing in a combination of bonds, S&P 500, small-cap stocks, MSCI EAFE index, and the FTSE Emerging Markets Index, we can boost our projected returns much higher.

Putting It All Together

Let’s walk through a couple examples that illustrate the difference between the old and new approaches.

Lee retired in 2007 with a nest egg of $500,000. As per conventional retirement advice, he decides to withdraw exactly $20,000 every year, adjusted for inflation. No matter what happens with his investment portfolio. Unfortunately for him, the market tanks soon afterwards, which leaves his portfolio value at $350,000. The $20,000 withdrawals now amount to over 6% – a rate far higher than his portfolio’s returns, which are concentrated solely in the S&P 500 and US treasuries.

Lee is also exceptionally healthy, and is still going strong at 2040. Unfortunately, his portfolio was unable to keep up with him, and he found his savings completely wiped out. He now finds himself, in his mid 90s, evicted out of the home he had spent decades living in.

Arya sees what is happening to Lee, and frets about the same thing happening to her. She decides to withdraw only $20,000 every year (adjusted for inflation) from her $600,000 portfolio – even lower than the 4% recommendation. 

Fortunately for Arya, she has better luck than Lee. Her investments are doing well. In fact, because she has invested in markets all over the world, her returns are even higher than expected. However, she remains disciplined about never withdrawing more than the fixed $20,000 amount every year. She finally passes away as a multi-millionaire, without fulfilling her lifelong dream of seeing the Pyramids, taking music classes, or owning a pet.

Adi pursues a different retirement plan. Like Arya, he too has saved up $600,000 and has invested in markets all around the world. Given his risk tolerance and holdings, he calculates that his portfolio will average real returns of 5% every year. And so, he withdraws 5% of his savings at the start of every year. In the first year, that comes out to $30,000. The next year, because of a 20% drop in his portfolio, he withdraws only $24,000. Ten years later, when the market has recovered and doubled, he finds himself withdrawing $48,000 every year.

Because his yearly income fluctuates, Adi has to adjust his budget periodically. This does prove to be inconvenient. However, his budget is still significantly higher than Arya’s, and he is able to fulfill his lifelong dream of traveling to all 7 continents and helping the less fortunate. But above all, Adi sleeps easy every night, knowing that despite whatever incremental ups and downs he may encounter, he will never find himself penniless like his unfortunate friend Lee.

Going Beyond 4%

The 4% rule may not have been perfect, but it made for a great starting point in financial planning. Instead of simply spending what we felt like, it taught us to think systematically about how to budget for the long run.

However, the 4% rule is due for a serious overhaul. By more realistically projecting for future investment returns, we can both avoid running out of money in a low-risk portfolio, and avoid unnecessary scrimping in a more aggressive portfolio. By diversifying our investments globally, we can grow our investment income by almost a third. And by course-correcting as our investments grow and shrink, we can avoid both unnecessary paranoia and the risk of catastrophic loss. It is time we rethought financial planning for retirement.


If the above sounds too scary, consider buying an annuity instead.

Thoughts?

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