Forget the 4% withdrawal rule

  @Money February 28, 2014: 10:01 AM ET
new retirement wade pfau

Wade Pfau, 36, professor of retirement income, American College, argues for a 3% drawdown.

NEW YORK (Money Magazine)

Choppy markets and rising health care costs needn't stop you from having the money for the retirement you want. We asked five of the brightest minds in retirement planning for their big ideas to help you cruise through the obstacles.

Below, advice from our first expert, Wade Pfau, an economist who studies retirement strategies.

If returns fall, you must withdraw less
Chances your money will run out in 30 years, based on initial withdrawal rate.
Withdrawal rate Forecast Historical
5% 82% 34%
4% 57% 0%
3% 24% 0%
NOTE: Assumes a 50% stock and 50% bond portfolio, and withdrawals that increase each year to keep pace with inflation. SOURCE: Michael Finke, Wade Pfau, and David Blanchett, 2013

Big idea: The most important retirement rule has changed

Almost every asset you can invest your nest egg in now looks expensive by historical standards. What's more, argues Wade Pfau, this has big implications for how you draw down from your savings the money you need to live on. If he's right, it throws one of the best-known retirement guidelines right out the window.

When Pfau, a professor of retirement income at the American College for Financial Services, says both stocks and bonds are expensive, he isn't predicting an imminent crash -- the Ph.D. economist is a number cruncher, not a tea-leaf-reading market forecaster. But he argues that basic math suggests asset prices have less room to rise, meaning the long-run outlook is for lower returns ahead.

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Based on studies of stock and bond returns since 1926, financial planners had settled on a benchmark for how much a retiree could spend each year without fear of running out of cash. It turned out that a person who invested half in stocks and half in bonds could spend 4% of his or her wealth in the first year, adjust that dollar amount for inflation in subsequent years, and still have money 30 years later. That worked in every historical 30-year period, as well as in most computer simulations based on the historical rate of return. Even drawing a hefty 5% worked more often than not.

But without strong stock and bond returns to help refresh your nest egg as you spend from it, those old numbers can't be relied on, argues Pfau.

"The probability that a 4% withdrawal rate will work in the future is much lower," he says. His new safe starting point: a 3% drawdown. That means that if you've saved $1 million, you're living on $30,000 a year before Social Security and any other sources of income you might have, not $40,000. Ouch.

Related: Do your retirement dreams match?

You may be relieved to hear that Pfau's idea is controversial. Michael Kitces, partner and director of research, Pinnacle Advisory, who has worked with Pfau on other research (more on that later), is one of many experts who think that the long historical record is still a decent guide to the future.

Yet William Bengen, the planner who in 1994 came up with the 4% rule, says some rethinking may be in order. "I think Pfau has done a great job of looking at the issues," he says. "Market valuations are important, and he may be right."

How to save for retirement in 2014

Here's the story the numbers tell, according to Pfau: The 10-year Treasury recently yielded only 2.6%, compared with its 3.5% historical average. Current 10-year yields generally tell you the total return you can expect over the next decade. (Even if yields go up from here, today's owners of bonds will suffer a loss of capital, since bond prices fall when yields rise.)

As for stocks, large companies listed on the S&P 500 index are priced at 25 times their averaged earnings over the past decade, according to measurements by Yale economist Robert Shiller. This gauge stands significantly above its average of 16. When Shiller's price/earnings ratio is high, lower returns typically follow over the next 10 years.

Related: 10 Best Places to Retire

As a result, Pfau estimates a fifty-fifty portfolio of stocks and bonds is likely to deliver a long-run annual average return after inflation of just 2.2%, less than half the historical rate. In a study with Michael Finke of Texas Tech and David Blanchett of Morningstar, Pfau found that with returns in that range, taking an inflation-adjusted $40,000 year out of a $1 million portfolio will drain your assets about 57% of the time, depending on the pattern of good and bad years. (More bad years early mean you will be more likely to run out.) Ratcheting back to $30,000 lowers to 24% the chance you will outlive your savings.

MAKE THE RIGHT MOVES

Save more if you can. That's the easy takeaway from Pfau. Not that it's easy, especially if you are close to retirement. To get $40,000 from a 3% withdrawal rate, for example, you'll need $1.3 million instead of $1 million. Working longer can help, but it won't fill all the gap. Other adjustments you can make, however, can take the sting out of Pfau's message.

Use diversification to stretch your cash. Even given the same long-run returns, a less volatile portfolio will tend to last longer. A portfolio that's not just large-cap stocks plus bonds, but is instead spread out to include small-company stocks, foreign stocks, and other asset classes, Pfau says, lets the safe drawdown from $1 million in savings rise to an initial $35,000 from $30,000.

Stay flexible. You can kick off your retirement with a larger starting income -- closer to the 4% rule -- as long as you are willing to correct your course when the market doesn't go your way. For example, in a year when your portfolio falls by 10%, you could try to reset your spending at 4% of the new, lower amount. If that's not enough to make ends meet, adjust what you can and then plan to skip cost-of-living increases for a few years.

Wade Pfau earned his Ph.D. in economics at Princeton and wrote his dissertation on Social Security privatization. From 2003 until 2013 he worked in Japan teaching officials from developing nations. But he made a mark in the U.S. by publishing attention-getting studies of retirement strategies. He now teaches at a college that certifies planners and has started a doctoral program in retirement planning.

On the pages that follow are big ideas from some of the retirement-planning world's sharpest minds:

Forget the 4% withdrawal rule: Wade Pfau, professor of retirement income, American College
You'll spend less as you age: David Blanchett, director of research, Morningstar Investment Management
Plan to pay for future health costs: Carolyn McClanahan, president, Life Planning Partners
Plan for the critical first decade: Michael Kitces, partner and director of research, Pinnacle Advisory
Social Security is the best deal: Alicia Munnell, professor of management, Boston College To top of page

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