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Media attention has focused on the long-standing “4% rule” and how economic and demographic realities have reduced that guideline. This article discusses related considerations and provides opportunities for retirees dealing with the new normal.
While most of the recent attention has been focused on inflation and its unwelcome impact, there has been another development that retirees or people planning for retirement should also heed. And it may prove to be an even bigger challenge. For the past 25 years, the so-called “4% rule” has served as a proxy for retirement planning. It was proffered by financial advisor William Bengen to provide an estimate – considering inflation – of how much retirees can withdraw annually over a 30-year period before exhausting their retirement portfolios.
This figure has been endlessly repeated. But there are two considerations to keep in mind. First, the original projection was based on an asset allocation of 50% in stocks and 50% in bonds. Retirees with a more conservative investment portfolio – e.g., a higher allocation to bonds – would already have to lower the original figure to keep from running out of funds. Retirees with a higher allocation to stocks could take more out but would then be subject to “sequence risk” – the very real possibility that they have a negative return while withdrawing funds in the early years of retirement, which could greatly impact their standard of living in retirement.
The second consideration is that the investing landscape has changed from the mid-1990s when Bengen did his research – particularly with regard to interest rates. As a result, many have questioned whether the 4% number is still valid. And indeed, in November, the investment research firm Morningstar weighed in with its research; it concluded that the 4% estimate should be revised downward to just 3.3%. (Bengen has challenged that research with his own updated findings.)
This is a significant change with a very real financial impact to retirees. Take the example of someone with $500,000 in their 401(k) plan. Using the 4% figure, they could withdraw $20,000 annually for thirty years. Substituting the 3.3% number put forth by Morningstar, they can only withdraw $16,500. That is a meaningful drop, perhaps equating to the cost of their annual utilities bill.
Now think about someone with only $255,000 in their 401(k) – which is in fact the average account size reported by Vanguard this June, based on the 5 million retirement accounts they oversee. The 3.3% rule for a portfolio that size only results in $8,419 every year – less than $1,000 a month.
And yes, Social Security helps. But even assuming a $2,000 benefit per month, that only gets you to $32,419 of total annual income based on an average 401(k) balance. That’s not much money to live on, even if your mortgage is paid off. Remember, you still have to pay Medicare Part B and D premiums. Add in property taxes and out-of-pocket medical expenses like dental and co-pays, and the reality for retirees is that their financial independence can be jeopardized.
What can be done? Especially if you can’t just “save more” right now? Here’s my list of steps that can be taken in combination to improve your finances as well as the quality of your retirement years:
1. Work longer (whether full-time or part-time) so that you don’t have to tap Social Security before age 70. That way you get an 8% higher monthly benefit and shorten the length of the retirement timeframe you have to fund.
2. Reduce expenses in retirement. How? The cost of living – healthcare, property taxes, rent and income taxes – can be meaningfully reduced without migrating to Florida. For example, a retiree moving from New Jersey to eastern Pennsylvania can be within an hour or so of friends and family with lower expenses – especially their state income tax on their 401(k)/IRA withdrawals, which are not taxed in PA. For the same reason, Nevada and Texas are swarming with California retirees.
3. Level your income in retirement. Don’t wait to withdraw from your taxable accounts at the same time that you have to start taking withdrawals from your 401(k) and IRA balances after age 72. You’ll end up with a much bigger tax bill and less income leftover – especially because of the “tax-cliff” that can occur for Medicare Part B premiums if your income increases later in retirement.
4. Consider the use of public transportation which is typically subsidized. This could be another factor on where to live in retirement. For example, Philadelphia’s transit system (buses, trains, etc.) is free for seniors age 65 and up. In Charlotte, people age 62 and up pay half fares;
5. If you own a home, consider a reverse mortgage as a final cushion for tax-free funds to tap yet stay in your home. You can also buy a home with a reverse mortgage which means you might have to put down less than 50% of the purchase price depending on your age (must be at least age 62);
6. Take advantage of “mortality credits” through lifetime and longevity annuities for the conservative portion of your retirement savings. These insurance products guarantee lifetime income and the monthly payment is higher because the benefit stops when you (or your survivor) dies. Depending on your age, the payments can yield 5%, 6% or more annually;
7. Consider buying long-term care insurance (LTCi) with a focus on home health care benefits. It’s not easy or cheap to get but you can take advantage of the tax-free nature of receiving home health benefits. A related consideration is having a ground floor master bedroom in retirement that facilitates receiving care at home;
8. Stay healthy. We know the drill; eat less and more healthfully, exercise more, go to the doctor, and stay engaged with friends, family and the community to maintain a sense of purpose. But you can also hit the parks. Walking, hiking, and biking can be done throughout retirement. If you’re near a national park, seniors can purchase a lifetime pass for $80. Most state parks have reduced or no entry fees for seniors. Connecticut’s state parks are free and New York’s state parks have free entry Monday through Friday for residents age 62 and up;
9. Keep mentally engaged. Many public colleges allow seniors to take a class each semester for free if there is class space. There is nothing more enjoyable than education for education’s sake.; and
10. Finally, don’t obsess about leaving a legacy. We would all like to leave family members and charities with funds when we pass. But first be sure that you are financially stable so that you don’t become a “reverse legacy” – financially dependent on others.
A closing thought: As most of us age we comprehend what is most important. Retirement is the best time to discard the “keeping up with the Joneses” mentality, or what I like to refer to as the “comparison culture”. It’s better to feel financially secure than to stretch yourself too far to keep up with the trappings of so-called success. Who cares how old your car is, or whether you’ve downsized to reduce your retirement expenses. The people you truly value don’t care, nor should you.
Dave Evans is a frequent author and speaker in the areas of employee benefits, retirement planning and financial literacy. Prior to co-founding 401kSleuth LLC, Dave was the CEO and Chief Compliance Officer (CCO) of a national trade association 401(k) Multiple Employer Plan (MEP).
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
