Posts
When the Personal Financial Planning column of your newspaper’s business section does an article about spending your assets in retirement, it will invariably mention the “4% Plan.” I don’t particularly care for the 4% Plan. Here’s why.
First, what is it? The 4% Plan is one plan for spending your accumulated assets in retirement. When you are done working and about to embark on your retirement, you add up all your retirement assets—your IRA’s, 401(k) accounts, savings accounts and the like—and multiply the total by 4%. That’s your allowance for the next twelve months. Then, after a year has passed, you increase your allowance by the prior twelve months' rate of inflation, and that becomes your next year’s allowance. And so on until both you and your spouse have passed on.
The 4% Plan has a lot to be said for it. It’s simple. It gives you certainty as to your standard of living from one year to the next. If you invest your assets wisely, you have a high probability that your assets will not be depleted before you pass on. And it's a plan. All good.
But it has a built-in flaw. Because it’s designed to carry a high probability that you will not outlast your assets, that necessarily means there’s a high probability that your retirement assets will build up and up and up. And then as you move into your seventies, eighties, and nineties, you likely will have more than enough to afford a meaningful increase in your allowance. Your nineties are a hell of a time for a raise. Where was that raise in your sixties when you could have put it to better use?
The flaw in the 4% Plan is that it fails to adjust to the reality of your changing assets. When it comes to your allowance, there’s a trade-off between certainty and size. And size matters. It essentially defines your standard of living. If you can accept fluctuations in your annual spending, your initial allowance can prudently be greater than 4%. Maybe 6% (but that’s a subject for another post). The more flexibility you have to turn your back on a portion of your spending if circumstances warrant, the greater the amount of spending you can prudently allow yourself. Another way to put that is: the less you must spend, the more you may spend. It’s Zen-like, isn’t it.
Tuesday, January 13, 2009
Subscribe to:
Post Comments (Atom)
As long as we are questioning the logic of the 4% rule, what would be the point of using the same number to determine the percentage of yearly income to save and the percentage of total savings to spend yearly? Given what you’re written about the Present Me and the Future Me, I’m trying to picture how the math would work out.
ReplyDeleteFinancial experts like you probably have a clear way of conceptualizing this. I’m still working on visualizing it, so perhaps you could help me out. Let’s say I earn $1 per year and set aside a yearly nickel for savings. Assuming I would have to pay perhaps a quarter to Uncle Sam, I would still be left with about 70 cents to spend yearly, right? What financial rules will insure that, when I retire, I will have enough nickels that spending a mere 4 or 5% of them yearly would bring me close to my accustomed spending level of 70 cents a year? I bet compounded interest factors in, and perhaps some other legs of the stool, but what about inflation and taxes? What assumptions are made between the ratio of working years to retired years?
-Jon
Washington, DC
Jon,
ReplyDeleteI agree with your conclusion. There is no logic to using 4% as a savings rate (when you're working), just because it might be a reasonable spending rate (when you're retired). It might turn out to be a good savings rate, but that would just be a coincidence. Your ideal savings rate will depend on a number of factors unique to you: How much have you saved to date? How many working years ahead of you? What is your investment plan? How much wiggle room do you have in your standard of living? Look for a few posts on this subject in the coming weeks.
Martin
Martin,
ReplyDeleteWhen I first read your 4% (or any fixed percent) yearly withdrawal, it made sense. But then I looked at your BBH position paper on Roth's. In comparing investment strategies, you used a term called "installment";
your BBH math suggests in the first year of one's retirement, one's withdrawal from lump-sum can be less that 1.5%, but that first year one also gets the earnings generated by the lump-sum (making one's installment greater than 9%).
Chris,
ReplyDeleteGood catch.
There's a reason for the difference. The purpose of the examples in the BBH Roth article was to compare two hypothetical scenarios--Roth vs. No-Roth. In constructing the examples I used a simplified hypothetical retirement spending plan that you could never use in real life.
Specifically, I assumed you knew exactly how long you were going to live and exactly how much investment return you would get each year, and exactly what inflation is going to be, etc. I kept all those things the same for both scenarios (Roth and No-Roth) to see which resulted in higher spending. I believe that's good enough to provide a basis for making the Roth decision.
But in real life, since you don't know how much your investments will return, or how long you will live, you end up with a spending approach that's pretty conservative--something like the 4% Plan.
The "installment" referred to in many of the examples, is the amount you would pay yourself if you knew how long you were going to live (25 years, in many of the examples), and how much your assets would return (8% in many of the examples), and what inflation would be (2.5% in many of the examples). Then paying that installment would completely deplete the pot as you took your last breath.
So the installment is neither the investment income you earn, nor 4%, but something else entirely.
You can sorta' make an apples-to-apples comparison. Look at Example 4, Exhibit E of the BBH paper. The 401(k) pot at that point under either approach is $47,583 (plus $14,379 outside the plan with the No-Roth approach). If you adopt the 4% Plan, with Roth your allowance is $1,903, all untaxed. With No-Roth, you get $1,903 all taxed, from the 401(k) plan, plus something-a-bit-less-than-4% of $14,379 from your taxable account. (If 4% is "right" for assets in a tax-sheltered environment, then the "right" percentage for assets in a taxable environment needs to be less. I'm not sure how much less, but let's call it 3.5%) Then, after tax, you end up with $1,645 (which is $1,903 x (1 - 40% tax rate) + 3.5% x $14,397).
In short, the BBH paper is simply not about what's a good spending plan. It's about whether you can expect a more luxurious life by Rothing or Not Rothing. It basically simplifies away the oomplex issue of how to adopt a spending plan.
I hope and expect in some future post, to actually combine the two issues. If I live that long.