Would you rather live on $36,000 a year or $60,000 a year?
That sounds like a question for a three-year-old rather than CFA Level 3 material, but it’s a surprisingly complicated and even controversial one for financial planners. A recent column I wrote on this got a quarter of a million views, oodles of reader emails, and some unsurprising pushback from people who make a living planning retirees’ finances.
There are two conventional rules of thumb for retirement: One is that we should have a diversified portfolio of risky and safe assets–60/40 is the common shorthand for this, denoting 60% stocks and 40% bonds. The other is that we can safely withdraw 4% of our nest eggs a year, boosting that by inflation each year, and not run out of money.
The “4% Rule” is 30 years old and is tied at the hip with a diversified portfolio–not necessarily 60% stocks and 40% bonds, but thereabouts. Both sound like back-of-the-envelope numbers, but they actually stem from a thorough study of many different mixes of assets under decades of historical conditions by advisor William Bengen. Only once, in 1966, would an American retiree have come close to running out of money with a diversified asset mix like that. That preceded a period of lousy stock market returns and surging inflation that led bonds to be dubbed “certificates of confiscation.”
The upshot is that a retiree with a $1.5 million nest egg could take $60,000 out of his or her account in year one and then adjust that in each of the following 29 years for the increase in the cost of living. Start at age 65 and, assuming you and your spouse make it to 95, you almost certainly have some money left and have maintained your lifestyle throughout.
Obviously that assumes all kinds of things that don’t correspond to any individuals’ actual circumstances. Not all couples are the same age and many retirement plans, like a traditional IRA or 401(k) in the U.S., force you to take more money out and subtract a healthy chunk of taxes before you can spend it after age 72—the dreaded Required Minimum Withdrawal. Costs for insurance and long-term care, especially in the case of dementia, can and often do bankrupt retirees in our perverse system. Uncle Sam will pay for Ozempic or Viagra, but if your husband or wife’s Alzheimer’s requires round-the-clock nursing home care then you might have to deplete your savings entirely before the government will foot the bill.
Leaving those unpleasant questions aside, let’s pretend we’re talking about one of those spry, affluent couples in the commercials for firms like Charles Schwab or (ugh) Edward Jones. You retire at 65 and spend the next three decades playing pickleball, seeing the grandkids, and learning to make pottery after which I guess you both die peacefully in your sleep. On top of whatever other sources of income you have, you start out with 4% and it’s all good—right?
Well not according to some newer research that points out that America’s experience was remarkably stable and prosperous. It looks at dozens of developed countries–some of which no longer qualify as such, like Argentina—and concludes that, if you want no more than a 5% chance of running out of money, 2.26% a year is your bogey. That would mean spending just $36,000 a year. Yikes.
I don’t think it’s a stretch to say that America’s experience in the coming decades won’t necessarily be as prosperous or even as peaceful as when it was the main western economic and military superpower. Predictions are hard, of course–especially about the future 😉. But let’s look at a period slightly more digestible than three decades. Taking a literal 60/40 portfolio made up of the S&P 500 and 10 year Treasury notes in that proportion, the odds of making the 9% nominal and 5.8% after inflation return typical of the last century look iffy in the next 10 years.
The 10 year note part is easy as far as nominal returns go: 3.8%. That will be more like 1.6% after inflation if market expectations are correct. If that’s seriously wrong then it’ll be on the downside as Washington sees no alternative but to let inflation run hot. They call it “the cruelest tax” for a reason.
Stocks are thornier, but probably the most reliable predictor of S&P 500 returns over a decade is Robert Shiller’s cyclically-adjusted price-to-earnings ratio. It has an almost perfectly inverse correlation with subsequent real returns. When in the top decile of most-expensive P/Es money management firm AQR calculates that the average 10 year real return for stocks has been just 0.5% a year. We’re now in the–gulp–97th percentile, by my calculations. So a 60/40 mix might only earn around 1% a year after inflation over a decade.
I love getting reader emails and questions but always have to be careful not to give explicit financial advice. Here are some general observations. A lot of them were about asset mix, which probably doesn’t matter much. If you’re more concerned about a near-term drop in seemingly-frothy stocks then a lower allocation to them, and probably more of a value and international tilt, makes sense. If you’re worried about inflation and a rise in corporate distress–I am–then buying short term Treasury notes and bills is prudent.
Obviously there’s a different sort of risk in being conservative which is simply not earning enough. Stocks have earned 350 times as much as T-bills compounded since 1928, and that starting date is hardly cherry-picked, coming right before the worst-ever plunge in equities following the Great Crash of 1929 and the Great Depression.
Investing is hard. So is saving, but I think that’s the most practical answer I can give to anyone worried about what sort of after-inflation returns to expect from their nest egg. Plan on saving a bit more and also spending a bit less when you no longer have a salary. Also, don’t assume that other sources of income will be there to cushion you, even if they have been promised. Social Security, for example, will deplete its retirement trust fund in nine years, according to the latest report of its trustees. After that there will be a 21% haircut. Some readers were incredulous and said that Congress would never let that happen, but the ability to just spend another couple hundred billion dollars a year at the stroke of a pen might not exist in 2033.
A few financial advisors said that the article’s assumptions were too pessimistic and that an even higher spending rate is fine, but then I searched and searched for a product their firms offer that guarantees inflation-protected income anything close to that high as an annuity. It seems like a no-brainer, but none of them offer this seemingly risk-free option for some reason. Weird.
So plan on living a bit more modestly. I don’t know if the “2.26% Rule” is right or too stingy—probably the latter. Earth could be destroyed by an asteroid as you’re a decade into retirement and living on Mac and Cheese, in which case you’ll feel silly for not having spent every last penny. Or you could run out of money at 90 and have lots of company because markets were so lousy, in which case maybe Uncle Sam will provide an actual safety net and you’ll have plenty of company in your penury.
These articles touch on our deepest anxieties. I think the main takeaway is that giant, obscenely-profitable companies exploit that and try to project a degree of certitude that math and history just don’t fully support.