The success or failure of adhering to the 4% rule depends on a both a retiree’s wealth and consumption. The rule, developed by William Bengen, calls for withdrawing 4% from savings at the start of retirement and then adjusting the amount upward each year in response to inflation. Accounting firm PricewaterhouseCoopers (PwC) says the rule may only work for affluent households.
PwC published a paper on the subject as part of an effort to promote its retirement planning product to financial advisers. Though there are some biases in the study, there are two big points worth paying attention to: consumption and wealth.
The 4% rule assumes linear growth in spending. Each year, the retiree is able to withdraw a larger and larger amount from his or her savings. Spending may not match this pattern. Citing work from Morningstar’s David Blanchett, PwC says consumption follows a pattern similar to a smile: higher in the early and late stages of retirement and lower in the middle part. (I’ve seen other research indicating the same pattern.) As a result, a disconnect exists between how withdrawals and spending are adjusted.
For wealthy households, this isn’t a problem. PwC says their high wealth allows for more in-retirement withdrawals to be taken than will be spent. For other households, it can be a potential issue. “Affluent households” who fall into the “mass market” category see consumption exceed withdrawals during five out of the first seven years of retirement, according to PwC. “Mass market households” fare even worse, with consumption exceeding withdrawals during the first nine years of retirement.
The sequence of consumption is a potential problem because it can require a higher amount of savings to be withdrawn early in retirement. To the extent that withdrawals exceed a maximum safe level early in retirement, longevity risk will be increased. This is because there will be a smaller balance to grow, which in turn increases of the odds of a retiree outliving his or her savings.
As far as what to do in response to this information, PwC suggests saving more and keeping a close eye on consumption. The firm also suggests monitoring what it calls “retirement fundedness,” which is the ratio of expected retirement savings to expected retirement expenses. Expected retirement savings is the present value of any future earnings, pension-type income (pensions, Social Security, etc.) and related benefits (e.g., Medicare) and investment savings. Expected retirement expenses is the present value of expected future consumption, debts and any amounts designated for bequests. It’s a ratio that requires many assumptions, but the idea is that all future assets and income streams should exceed future expenses. PwC says that ratios above 105% suggest the retiree is constrained (meaning adjustments may need to be made), while ratios above 145% imply the retiree is overfunded and can use the 4% rule.
While PwC is trying to promote its own proprietary service, the concept of funding expected liabilities first is not a new concept to the world of retirement planning. There is also research calling for a variable withdrawal rate instead of a fixed withdrawal rate, which allows for greater flexibility. (I’ve highlighted articles discussing both concepts below.) The big key is to understand whether your assets plus any pension or Social Security income are able to cover your expenditures without taking too big of a withdrawal—especially early in retirement—and be willing to make adjustments as necessary.
- Retirement Planning: Focus First on Covering Fixed Expenses – Once all fixed costs have been immunized, withdrawal rates no longer matter.
- A More Dynamic Approach to Retirement Spending – Instead of sticking to a fixed withdrawal rate, fluctuate it within a preset range.
- Retirees: What Withdrawal Rate Do You Use? – Tell us on the AAII.com Discussion Boards
It will be another busy week for large-cap earnings with 160 members of the S&P 500 currently scheduled to report. Included this group are Dow Jones industrial average components Apple (AAPL) on Monday; Merck & Co. (MRK) and Pfizer (PFE) on Tuesday; Exxon Mobil (XOM) and Visa (V) on Thursday; and Chevron (CVX) on Friday.
The Federal Open Market Committee will hold a one-day meeting on Wednesday.
The first economic reports of note will be released on Tuesday: the February Case-Shiller home price index and the Conference Board’s April Consumer Confidence survey. Wednesday will feature the preliminary estimate of first-quarter GDP and March pending home sales. March personal income and spending and the April Chicago PMI will be released on Thursday. Friday will feature the April ISM manufacturing index, the University of Michigan’s final April consumer sentiment survey, the April PMI manufacturing index and March construction spending.
- Nine Rules for Smarter Investing
- 16 Financial Ratios for Analyzing a Company’s Strengths and Weaknesses
- How Interest Rate Changes Affect the Price of Bonds
Neutral sentiment is above 45% for a third consecutive week, the longest such streak since 1989. Optimism declined slightly, while pessimism rose slightly.
Bullish sentiment, expectations that stock prices will rise over the next six months, declined 0.6 percentage points to 31.5%. The modest drop keeps optimism below its historical average of 39.0% for a seventh consecutive week. The last time optimism stayed below average for a longer period of time was an eight-week stretch between June 19, 2014, and August 7, 2014.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, edged up 0.2 percentage points to 45.3%. This week’s rise keeps neutral sentiment above its historical average of 30.5% for the 16th consecutive week.
Bearish sentiment, expectations that stock prices will fall over the next six months, declined 0.4 percentage points to 23.2%. The historical average is 30.5%.
There are two observations to make regarding neutral sentiment. First, this is the longest streak with neutral sentiment at or above 45% since a four-week stretch between December 16, 198,8 and January 6, 1989. (Neutral sentiment fluctuated between 46% and 54% over that span.) Second, since the start of 2014, neutral sentiment has been above its historical average of 30.5% on 56 out of 69 weeks.
Historically, unusually high levels of neutral sentiment have been correlated with better-than-average market performance over the following six- and 12-month periods. (See Analyzing the AAII Sentiment Survey Without Hindsight in the June 2014 AAII Journal for more information.) There is no guarantee history will repeat in the future, however.
Keeping some AAII members encouraged are the ongoing bull market, sustained economic expansion, earnings growth and still-accommodative monetary policy. Causing other AAII members to be cautious or pessimistic are prevailing valuations, recent price volatility, geopolitical events, the pace of economic growth, the impact of the stronger dollar in earnings growth and worries that a notable decline in stock prices could occur.
This week’s special question asked AAII members what they thought about the NASDAQ rising above 5,000 for the first time since 2000. About 11% of respondents said it was basically a non-event, with some describing the move as not revealing anything about the market’s current valuation. Nearly 8% said reaching 5,000 was a positive. Six percent thought it was about time the NASDAQ returned to 5,000. Another 6% of said it will either be difficult for the NASDAQ to stay at this level or that reaching 5,000 is otherwise a reason for concern that the market is getting overpriced. A little more than 3% of respondents view valuations as being cheaper now than they were during the technology bubble.
Here is a sampling of the responses:
- “It’s about time. This time seems much more sustainable than last time.”
- “I really don’t think it was that significant.”
- “P/E ratios are realistic now, especially when compared to the rapid ascent to 5,000 in 2000.”
- “It’s been up for a long time. It’s time for a drop in the market.”
- “Would like it better if the value of money hadn’t declined over the last 15 years.”
- “A good thing.”
Bullish: 31.5%, down 0.6 points
Neutral: 45.3%, up 0.2 points
Bearish: 23.2%, up 0.4 points
Local Chapter Meetings
April 16, 2015 Buck Conventional Wisdom When Taking Retirement Withdrawals
April 9, 2015 The Growing Popularity of Index Funds
April 2, 2015 The Bond Strategies Used by Advisers
March 26, 2015 200-Point Moves in the Dow Are No Longer Significant