A Money Magazine reader recently submitted this question to Walter Updegrave, a senior editor and well known personal finance writer:
The 4% rule seems to have become the conventional wisdom for drawing money from your savings in retirement. But I believe the rule is flawed. I think it might make more sense to choose a percentage of your savings that you will withdraw annually and then just apply that percentage to your savings balance at the beginning of each year so you would have more money to spend in years when investment returns are good and less to spend in years when returns are bad. What do you think?
The response listed several available strategies for generating retirement income from available resources. The discussion of the strategies included well-recognized flaws.
1. Fixed Annuities. A fixed annuity can provide a predictable income. There are three negatives: (a) the security of the income depends on the financial stability of the insurance company; (b) you generally lose access to the principal; and (c) most fixed annuities are not indexed to inflation.
2. 4% Withdrawal Rule. This strategy states that you begin year 1 by withdrawing 4% of the value of your retirement income fund. You maintain that withdrawal amount each year, adjusted by the rate of inflation. For example, if in year 1 your income fund had a value of $500k, and the inflation rate is 3%, in year one you would withdraw $20,000. In year two you would increase your withdrawal amount by 3% to $20,600. There are two problems with this scheme. First, if the market tanks like it did in 2008 – particularly if early in your retirement – your money is likely to run out way before you do. Second, if the market does well, you will end up with a lot of money that you could have used for discretionary spending. Instead, it will go to your heirs.
3. Fixed Withdrawal Rate. This is what the reader proposed. Instead of maintaining a constant withdrawal amount (4% of your year-one retirement fund) adjusted by inflation, you apply the 4% rate to the value of your retirement fund at the beginning of each year. In this way, if the market declines, so does your withdrawal amount. Although this strategy is likely to extend the life of your retirement income fund, your income and lifestyle can change significantly from year-to-year. That is counter-productive to what we want in our retirement.
What is the answer? To me, the answer is a Failsafe Retirement Income Plan, using TIPS and I-Bonds, to provide your basic income needs. What is left over you can invest for discretionary income.