Not Just a Number

Aaron Brask

MANY PEOPLE TELL ME they need, say, $1 million or $2 million to retire, effectively equating retirement with a dollar amount. But there’s more to retirement than just the financial side. It’s a major turning point that will alter virtually all of our priorities—how we spend our days, how we interact with loved ones, what we care about and what we hope to achieve.

Even if we focus only on the financial side, we can’t sum up retirement with a single number. Many people have historically relied on the 4% rule—the so-called safe withdrawal rate (SWR). Based on William Bengen’s pioneering research, this rule says we should be able to withdraw 4% of our portfolio in the first year of retirement, and thereafter increase that dollar amount each year by the inflation rate, without running out of money. For example, if we have a $1 million nest egg, we could take out $40,000 (4% of $1 million) in the first year. If inflation is running at 2% a year, we’d withdraw $40,800 ($40,000 x 1.02) in year two, and so on.

The 4% rule was determined by figuring out what withdrawal rate would have been successful historically even in the worst markets. Since Bengen’s original 1994 study, he and others have introduced updates to his methodology that increased the SWR by improving a nest egg’s diversification.

On the other hand, studies have also highlighted the link between stock market valuations and withdrawal rates. In other words, expensive markets may require withdrawing less each year. Current bond interest rates and stock dividend yields are both near their historical lows, as you can see from the accompanying chart. This concerns me—and it may require a withdrawal rate lower than 4%.

To be fair, such caution may not be necessary for three reasons. First, for many seniors, retirement income isn’t solely a function of interest and dividends. It also involves chiseling away at principal itself. That said, relying on principal means worrying about sequence-of-return risk—the danger that market prices will be down sharply when we need to sell to fund retirement spending.

Second, low dividend yields may not be the warning sign they once were. Over the past few decades, there’s been a trend toward returning corporate cash to shareholders via stock buybacks. Combine those buybacks with cash dividend yields, and the total yield on stocks doesn’t look so alarming. Buybacks may just result in getting less dividends now, but faster dividend growth in future.

Third, inflation may remain low. Bengen has pointed to inflation as being “the retiree’s worst enemy.” If this enemy is weakened, that’s all the better for retirees. Recent headlines and bond market volatility have reflected renewed concerns about inflation. But if the multi-decade trend toward lower inflation continues, this could minimize one of the worst threats to retirees who use the 4% rule.

How am I advising my clients? It depends on someone’s age and time horizon, but I’m more likely to suggest withdrawal rates closer to 3.5%. The implication: $1 million isn’t what it used to be. For retirees, what matters isn’t the size of their nest egg, but the lifestyle it can support—and I fear $1 million won’t support the lifestyle it once did.

Aaron Brask is an investment advisor based in West Palm Beach, Florida. His practice and research focus on low-cost, tax-efficient strategies for investing and retirement. Outside of work, Aaron enjoys sports, traveling, and spending time with his wife and two young children.

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