Previous generations, retiring with defined-benefit pension plans provided by employers, seldom concerned themselves with the investments that secured those plans. That was the employer’s problem — except when the investments turned out to be insufficient to make the required pension payments, when it would suddenly become the retirees’ problem. But that was an uncommon aberration.
This generation of retirees is much more likely to depend on defined-contribution plans, in which investments are under the control of the retiree. Whereas defined-benefit plans promised payments for the retiree’s life span, however long that might be, defined-contribution plans leave the retiree with a nest egg of financial assets to be drawn on as the retiree, often with the advice of a financial adviser, considers prudent. Draw too much and you run out of money; draw too little and you needlessly impoverish yourself.
Not all retirees face the challenge. Those who saved little or nothing during their working years and are wholly dependent on Social Security face an impoverished retirement, no matter what. At the opposite pole, those who have accumulated large amounts of assets can draw what they like without worrying about it. Spending more simply means leaving a smaller estate.
The challenged retirees are those in between, who have assets that may or may not last through their life span, depending on how carefully they are managed and how long they live. In most cases, the assets held by challenged retirees are entirely or largely common stock because over long periods, investments in common stock have yielded the highest returns.
The downside of having one’s nest egg in common stock is that the returns are unstable and can be negative for extended periods. Somehow, challenged retirees must figure out how to steer themselves safely between the Scylla of impoverishment from the premature depletion of assets and the Charybdis of unnecessary deprivation from excessive caution.
To provide some guidance to that challenge, my colleague Allan Redstone has developed tables that, for a specified nest egg amount and life expectancy, show the monthly draw amounts associated with estimated probabilities of nest egg depletion. The tables are based on an available database covering monthly rates of return on common stock during the period 1926-2012 and assume a constant annual inflation rate of 2 percent.
Here is an example. When retiree Jones stopped working at 64, he had a common stock nest egg valued at $1 million and a life expectancy of 20 years. The median initial draw amount, based on 733 20-year periods during 1926-2012, was $8,951. The median rate of return that made this draw amount possible was 11.3 percent. If the same median historical return experience occurs over the next 20 years, and Jones lived exactly that long, he could draw $8,951 monthly (increasing at 2 percent per year), with the last check that closed his account arriving the month he died.
But there is an estimated probability of 50 percent that $8,951 will turn out to be too high and he will run out of money. If he started out drawing $6,343, which requires a rate of return of 6.6 percent, the probability of running out drops to 20 percent. To reduce the risk of running out to 5 percent, he would have to reduce the initial monthly draw to $4,178, which requires a return of only 1.9 percent.
There is the additional risk that he will live past his life expectancy. Extending the period to 25 years, the initial draw with 5 percent risk would be $3,741, requiring a rate of return of 2.9 percent.
The uncertainties involved in managing investments support an industry of investment advisers. They have come up with the widely cited “4 percent rule,” which says that it is probably safe for a retiree to draw an amount every year equal to 4 percent of the current value of a stock portfolio.
A weakness of the 4 percent rule is that the retiree does not know how much risk is involved, or the extent to which the risk would be increased by going to 4.5 percent, or reduced by going to 3.5 percent. However, the Redstone tables can fill that gap. Applying the 4 percent rule to retiree Jones, the draw amount would be $3,333, which over 25 years carries a risk of running out of about 4 percent.
Information on the probability that a specified draw amount will result in the retiree running out of money does not make the process of deciding how much to draw any easier. On the contrary, basing the decision on probabilities is the difficult way. The easy way is to just accept the adviser’s recommendation.
The capacity to generate a complete table of draw amounts and rates of return for a common stock nest egg of any size, organized by percentiles and periods, will be available on my website.
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Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
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