The 2.7% Rule for Retirement Spending

Summary

Ben Felix, a portfolio manager at PWL Capital, critiques the 4% rule for retirement spending, suggesting a safer withdrawal rate between 2% and 3%. He explains that the 4% rule, based on historical U.S. stock and bond data, doesn't account for the global variability in markets or increased life expectancy. Felix argues for more conservative withdrawal strategies and emphasizes the importance of international diversification, longevity planning, and the use of alternative strategies like annuities or government pensions. Ultimately, he concludes that a 2.7% safe withdrawal rate is more realistic for many retirees.

Takeaways

• 😀 The 4% rule, originally proposed for safe retirement spending, may no longer be applicable for many people today due to changes in market conditions and longevity expectations.
• 😀 Recent research suggests a safe withdrawal rate of 2.7% for retirement spending, significantly lower than the historical 4% rule.
• 😀 The 4% rule was based on U.S. stocks and bonds, which historically performed exceptionally well, making the data potentially biased for future expectations.
• 😀 The original 4% rule assumed a 30-year withdrawal period, which may be too short given increasing life expectancies.
• 😀 The U.S. equity markets have been more resilient and profitable than most other developed nations, raising concerns about the sustainability of past U.S.-centric data.
• 😀 The 'equity premium puzzle' refers to the U.S. market's unexpectedly high returns, driven by a mix of luck and favorable circumstances, such as avoiding major global disasters.
• 😀 A safer withdrawal rate is now considered to be around 2.7%, factoring in the broader global context, diverse market conditions, and longevity risks.
• 😀 International diversification in retirement portfolios has shown to improve safe withdrawal rates, with the optimal balance being a 60% domestic, 40% international stock allocation.
• 😀 The U.S. market’s historical data should be taken with caution, as it doesn't fully represent the variability of other developed countries or market failures.
• 😀 Future retirees, especially those from nations with longer life expectancies like Canada, may face a higher risk of running out of money if they follow the 4% rule.
• 😀 While the 4% rule offers a general guideline, it’s important to remember that retirement withdrawals should be flexible, with the possibility of adjusting withdrawals based on changes in income and pensions, as well as market conditions.

Q & A

What is the 4% rule for retirement spending?

The 4% rule suggests that a retiree can safely withdraw 4% of their investment portfolio in the first year of retirement and adjust that amount for inflation each year, with minimal risk of running out of money.

Why has the 4% rule been questioned in recent research?

Recent research suggests the 4% rule may no longer be reliable because it was based on historical U.S. stock and bond returns, which may not be representative of future returns. Additionally, it assumes a 30-year withdrawal period, which might not be long enough for many retirees today.

What is the new recommended safe withdrawal rate according to recent research?

The new recommended safe withdrawal rate, based on recent research, is closer to 2.7%, taking into account a broader dataset of developed markets, longevity risk, and international diversification.

What is the equity premium puzzle mentioned in the video?

The equity premium puzzle refers to the phenomenon where U.S. stock returns have been much higher than predicted by economic models, driven by factors like good luck (avoiding catastrophic events) and learning (lowering required returns over time).

How does the study account for survivorship and data biases?

The study accounts for survivorship and data biases by using a comprehensive dataset covering 38 developed countries and 2,500 years of asset class returns, including countries with failed markets or difficult-to-obtain data.

What role does international diversification play in retirement portfolios?

International diversification improves the safe withdrawal rate. For example, adding international stocks to a 60/40 portfolio can increase the safe withdrawal rate from 2.26% to 3.02%, despite additional costs like higher fees and less favorable tax treatment.

What is the significance of longevity in determining safe withdrawal rates?

Longevity significantly impacts safe withdrawal rates because retirees today are expected to live longer than previous generations. For example, a Canadian couple retiring today has a 50% chance of living another 29 years, which requires more sustainable spending strategies.

How does the 2.7% withdrawal rate compare to the 4% rule for retirees in 2022?

The 2.7% withdrawal rate is more realistic than the 4% rule, as it accounts for longer life expectancies and broader global market conditions. In 2022, a U.S. couple retiring at age 65 faces a 17.4% chance of depleting their wealth with a 4% withdrawal rate, making a lower rate like 2.7% more sustainable.

Why is it important to consider taxes when applying the safe withdrawal rate?

Taxes are an important factor to consider because they can reduce the actual spending available to retirees. The 2.7% withdrawal rate assumes tax-free investments, but taxable investors may need to adjust the withdrawal rate downward.

What is the role of government pensions and annuities in retirement planning?

Government pensions and annuities can help offset the risk of outliving one's savings. Retirees may also consider deferring pensions to increase their benefit or allocating a portion of their portfolio to annuities to ensure consistent income in retirement.