Last Updated Sep 22, 2011 6:49 PM EDT
Before we dig into the conclusions of this paper, let's briefly review the four percent rule, which goes like this:
- Invest in a portfolio balanced between stocks and bonds
- Withdraw four percent of your account in the year you retire
- Give yourself raises for inflation each year thereafter.
One common analytical argument for the four percent rule goes like this:
- Look at every possible 30-year retirement period in the past, for as many years for which reliable, historical investment data is available.
- Assume you invested in a specific asset allocation between stocks and bonds and earned historical rates of return.
- Calculate the safe withdrawal rate for each of these periods, given the specific asset allocation.
Another common analytical argument for the four percent rule constructs a probabilistic model that prepares 500 to 1,000 projections of investment returns over 30 years based on historical returns and potential deviations from these returns. The probability of failure (i.e., outliving your retirement savings) is then estimated under various withdrawal rates and specific asset allocations. These models deem a withdrawal rate to be safe if the estimated failure rate is below certain thresholds, such as one out of 20 (5 percent) or one out of 10 (10 percent).
Both types of analyses can be used to analyze periods of retirement different from 30 years, and as you'd expect, shorter retirement periods can generate higher safe withdrawal amounts, and longer periods lower safe withdrawal amounts.
With this background in mind, let's now look at the paper that calls into question the safety of a four percent withdrawal rate in today's economy.
Next: Why four percent may not be a safe withdrawal rate in today's environment