3% is Depressingly Small

In a comment to April 27’s post, David points out how depressingly small 3% is. It simply ain’t that much. If that’s all your savings can generate, it doesn’t sound like you’re in for a luxurious retirement. That’s the main reason I don’t care for the 4% Plan (or 3% Plan or 3.5% Plan). It’s too darn miserly.

First, let me recap. When you retire, you need a plan for determining how much of your assets you’re going to spend each year. The goal is to spend as luxuriously as possible, without imprudently risking running out of money before your ticket is punched. That’s your “Retirement Spending Plan.”

One such plan, often written about in the financial press, is the 4% Plan. Add up your assets on the day you retire, multiply by 4%, and that’s your allowance for the year. Then the following year, increase the dollar amount of your allowance by inflation. And so on, and so on. As pointed out in April 27's post, 4% is the “right” percentage for assets in a tax-favored retirement account. But then if it’s a traditional IRA or other pre-tax account, income taxes will shave your after-tax spending (the part you can actually enjoy) down to 3%. (Not so with Roth accounts.) And maybe the “right” percentage for taxable accounts is 3.5% rather than 4%. Either way, these numbers—and therefore your allowance—simply aren’t that big. They do depress one, don’t they.

What are you buying by limiting your first year withdrawal to a miserly 4%? Two things. One is the security that you will not likely run out of spending money during your lifetime. That aspect of retirement security is, in my view, well worth the price.

But you’re buying something else for which you are paying dearly; too dearly in my view. That is the ability not to have to ratchet down your lifestyle in years when the financial markets are unkind. (And in the course of a typical retirement, there will be such years.) The 4% Plan allows you, to a degree, to ignore short-term losses and simply keep spending according to plan. But if you have some fat in your lifestyle—expenses you can cut back if need be—you can use that flexibility to buy a more luxurious lifestyle. You just have to be willing to have your annual allowance float with the ups and downs of the financial markets, and therefore your retirement assets. Then you can increase that 4% to something closer to 6%. That’s a 50% pay increase! Moreover, that 6% can gradually get bigger and bigger as your life expectancy decreases. Life is grand!

But you can’t have it both ways. If you increase your payout percentage you have to give up on the certainty of a fixed allowance. You have to be willing to cut back on your discretionary expenses when Mr. Dow Jones tells you to. And 2008 taught us that Mr. Dow Jones can be very cruel indeed. Cutting back is easier said than done.

More on the 6% Plan in future posts.