How to avoid outliving savings, losing ground to inflation in retirement

August 18, 2013 

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One of the most asked questions in retirement planning is: “How much money should I save each year for retirement?”

However, a better question is: “How much savings can I spend each year without outliving the money or losing ground to inflation?”

While the latter is a much debated question in financial planning, Bill Bengen, a certified financial planner in California, was one of the first to address this and his research still provides a pretty good answer as well as a base for other studies.

By examining financial and market statistics back to 1926 and running hundreds of “what if” scenarios, he developed his “4% Rule” in the early 1990s.

He ran tests on 30-year windows from 1926 forward – such as 1926-1956 and 1953-1983.

Modified some since, but in summary it works like this: You can spend 4.5 percent of the assets in your accounts in your first year of retirement and increase that annual dollar amount each year by the inflation rate and your nest egg will last at least 30 years under all the historical scenarios tested through 2012.

For example, if you have $500,000 in investable assets, you can spend 4.5 percent of this amount, i.e. $22,500 in the first year, adjust this by inflation in subsequent years and you would not have run out of money in any 30 year window tested.

If you retirement goal is to spend $50,000 per year and you have $20,000 in Social Security and/or pensions, you will need to spend $30,000 from your own portfolio.

To do this, assuming the 4.5 percent spending rate, you would need a portfolio of $667,000 ($30,000/.0045). Now you can answer the big question of how much do you have to save because you know the spending amount.

The amount to save will depend upon the years to retirement and the annual rate of return. Continuing the prior example, assuming a worker is 30 years from retirement, has no savings and can earn 7 percent annually, he/she would need to save $550 per month.

A key driver to this research revolves around how your portfolio is invested. Bengen’s research shows that being too conservative is just as detrimental as being too aggressive.

His sweet spot to stocks is between 50 percent and 75 percent. A lower rate typically does not keep up with inflation and you will deplete the portfolio faster due to a lack of growth. A higher rate produces too much volatility and actually reduces the 4.5 percent to about 3.9 percent in the studies.

Does Bengen’s method really guarantee you won’t outlive your cash?

His research uses a 30-year retirement span, presumably starting at age 65. However, actuarial tables for couples that age suggest at least one spouse will live to 95 or beyond 18 percent of the time.

Could this pose a problem? Certainly, but this research is a rule of thumb and not a holy grail.

A retiree and his/her planner should recognize a spending problem in advance and address this in the ongoing financial planning process. Planning around one’s risk tolerance and projected longevity should also play a role in the portfolio allocation and thus the actual withdrawal rate.

Life is a journey, so plan for it.

Neil A. Brown is a certified-public accountant and certified financial planner with Burkett Financial Services, LLC in West Columbia. For more information, call (803) 200-2272 or visit www.uscneil.com

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