You often see the “3% rule” quoted in retirement literature. Many times it is applied incorrectly, so I’d like to revisit the rule, clear up some misconceptions, and let Dick and Jane show you how it works in their retirements.
Financial planner William Bengen is responsible for the 3% rule, although that’s not what he called it. Actually it’s the 4.5% rule, but he didn’t call it that either. He called it “Safemax,” and it goes like this:
“If you spend 4.5% of the assets in your tax-deferred accounts in your first year of retirement and increase that annual dollar amount each year by the inflation rate, your nest egg will last at least 30 years under all the historical scenarios tested.”
Bengen realized that relying on the last 80 years’ averages for stocks, bonds, and inflation only helps the hypothetical retiree that actually experiences those exact averages. But what about a retiree in a real 30-year time chunk during that historical period? How would he have fared in the best of times and in the worst of times?
His research showed that a retiree in the worst 30-year time stretch over the 80 years that he studied (which included some whopper recessions and even the Great Depression), would not have run out of money if he withdrew 4.5% of his nest egg the first year of retirement, and then adjusted that dollar amount each year for inflation.
-This only held true for retirees that could stomach at least 50% of their portfolios in equities. If you want to do it all on treasuries, the rule does not apply to you. Your money would not have lasted in the worst of times if you were not willing to invest at least 50% in equities.
-In many of the time periods studied, your money would have lasted even longer than 30 years (or put a different way, you could have withdrawn more than 4.5% over those 30-year stretches). The Safemax is purely to figure out what would have been the worst outcome. In the case of the 4.5% rule, the worst outcome would have been that you would be left with no money at the end of 30 years.
-Thirty years isn’t long enough for a healthy retiree wanting to retire in her 40’s or 50’s. That’s why I often quote the 3% rule. It’s just the 4% rule adjusted for the research showing the Safemax for 50 years instead of 30 years.
-The rule does NOT say that you withdraw 3% of your assets each year. That is a common misconception. Read this again: You withdraw 3% of your assets only the first year and then adjust that dollar amount each year for inflation. After the first year, you never again multiply your ending assets by 3% to come up with the withdrawal rate.
Meet Dick and Jane
Dick and Jane are both 50 years old. The year is Year 1, and the S&P index is at 900. Dick and Jane each have identical $1 million portfolios of which 50% is invested a well diversified mix of U. S. large-, mid- and small-cap stock funds as well as international developed- and emerging-market funds. The other 50% is diversified among short-, long- and mid-term bond funds and includes a 3-year supply of living expenses in an FDIC-insured savings account. (As the author of this story, I will not let Dick or Jane invest 100% of their portfolios in the 30 stocks that make up the DJIA. That would be foolish, and as their advisor, I would not let them do something foolish.)
Dick decides to retire right now because his retirement budget is $30,000 and that represents exactly 3% of his next egg. I failed to mention that Dick and Jane live in Podunk, where the cost of living is very low. I also I failed to mention that Dick really hates his job. (And of course Dick doesn’t know this now, but he will live exactly 50 years in retirement, unfortunately dying one day short of his 100th birthday in a tragic bungee jumping accident.)
Jane likes her job ok and wants to stick it out at least for another five years, to hopefully let her portfolio recover from a Big Recession. She retires in Year 5 when the S&P is at 1,400. Now, of course her portfolio is more than the $1 million it was in Year 1, but it is NOT 56% higher as would be indicated by the measure of the S&P index. Only half of her nest egg was even exposed to the stock market, and some of that was in international funds, so her portfolio is 20% higher than it was at Year 1, now at $1.2 million. Dick’s is of course smaller since he has been taking withdrawals from his identical portfolio for five years.
(It might be a good time to tell you that Jane also lives for 50 years in her retirement, dying of natural causes on her 105th birthday.)
Between Year 1 and Year 5 inflation has been 3.5% per year, so while her budget was identical to Dick’s five years ago, $30,000 doesn’t get you what it used to, even in Podunk. Dick is now withdrawing $34.5k (his inflated base amount). Three percent of Jane’s $1.2 million portfolio puts her first year withdrawal Safemax at $36k, which by the way, she really doesn’t need because she already lives on $34.5k—the inflated $30,000. But she has expensive taste in shoes, so she decides to take out the whole $36k maximum.
Now some of you might be thinking, that’s so unfair, why does Jane get to take out more for the rest of her life than Dick does? Just because of the arbitrary place on the S&P (and the affect on her respective portfolio)?
The 3% rule does not say that Dick can’t take out more. The rule just says that if Dick had been unlucky enough to retire during a 50-year period that was as bad as the worst 50 years in recent history, he wouldn’t run out of money. In fact, it’s likely that he didn’t retire in the worst 50-year stretch of history given that the market went up 56% in the first 5 years of his retirement.
In fact, it’s likely that Jane’s 50-year stretch is going to be worse than Dicks, given that Dick already experienced a great 5 years in the beginning of his retirement. The next 45 years, they experience the exact same market together, and then even if Jane experiences a stellar market in her last 5 years of living, it would be on a much smaller asset base by that time. But the rule says that even if she experiences a 50-year stretch as bad as the worst in recent history, she won’t run out of money either.
So what does this rule mean for Dick and Jane? Since Dick and Jane’s retirement overlapped 45 of the same years, and Dick had a stellar first five years in the market, if either of them experienced the worst 50 years, it would have been Jane. If Jane did, indeed experience the worst 50 years, based on Bengen’s research, this means that Jane dies with no money, and Dick dies with some money left. That’s all the rule says.
Raise your hand if you have any questions.
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