Spending in Retirement: Is 3 the New 4?

Cheri Franklin |

CNNMoney Financial writer Walter Updegrave recently addressed himself to answering the following question from an anonymous reader: “How large a retirement nest egg do I need if I want to draw $60,000 a year from it and have my money last 30 years?”

Of course, there is no easy answer to this age-old question. The most often-cited work is William Bengen’s October 1994 Journal of Financial Planning article, “Determining Withdrawal Rates Using Historical Data,” the source of the famous 4% rule which posits 4% of the initial portfolio value with inflation-based increases as a safe withdrawal rate. For the question above, the size of the nest egg would have to be $1.5 million.

Updegrave cites more recent work by Wade Pfau, professor of retirement income at the American College who thinks an initial withdrawal rate of roughly 3% is more appropriate given today’s investment landscape. To understand just how much the landscape has changed since Bengen’s original article, we need only look at the massive decline in the 10-year Treasury bond yield from 7.6% to 2.4%. For equities, the Shiller cyclically-adjusted price-to-earnings ratio has increased from 20.2 to 28.8, its highest level since the dot-com bubble at the beginning of this century (more on that here). A 3% withdrawal rate would require a $2 million nest egg.

If 4% was the safe withdrawal rate under 1994 conditions, then it is readily arguable that 3% is more appropriate to today’s conditions. However, perhaps we should take a step back and ask if a single inflation-adjusted withdrawal rate that will be adhered to for the next 30 or so years truly makes sense? When we consider the four major risks facing retirees (sequence of returns, inflation, longevity, and catastrophic health events), the whole constant real spending model breaks down. More recent research by David Blanchett in the May 2014 Journal of Financial Planning (“Exploring the Retirement Consumption Puzzle”) suggests that real retirement spending actually decreases on average until about age 84 when it starts to increase due to health-related costs. Wade Pfau calls this “The Retirement Spending Smile.”

It is important to remember that no two person’s future spending patterns are alike, so we would not suggest a one-size-fits-all solution for our clients. Three important factors we would evaluate include current health/life expectancy, the desired wage replacement ratio, and other sources of income such as Social Security, pensions, and rental property. If you would like to learn more about how Clarity can help you plan your retirement saving and spending, please e-mail us at info@clarityca.com or call us at 800-435-4635.