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IRA and 401k Retirement Drawdown: Don't Die Broke!

Spend your last dollar as you spend your last breath. Bounce the last check. Die broke!
I frequently hear these goals at my retirement planning workshops from people who are planning to draw down their accumulated IRA, 401k, and retirement savings to generate retirement income. The first two goals are easier said than done, of course, since nobody knows exactly when they'll die. And while many people will achieve the third goal -- dying broke -- it won't be because of their stellar planning skills. Instead, they'll be broke for many years before they die, because they depleted their retirement savings too rapidly in retirement.

So how can you draw down your retirement savings so that you don't outlive your savings? This significant challenge is the subject of my ongoing series on using IRAs, 401ks, and retirement savings to generate retirement income, starting with IRAs and 401k: 3 Ways to Generate Lifetime Retirement Income. The odds are very good that you won't outlive your savings with two of these three ways -- using just interest and dividends, and buying an immediate annuity.
This post digs deeper on the third method -- withdrawing investment earnings and principal cautiously so that you minimize the odds of outliving your retirement savings. The shorthand name for this unfortunate outcome is "actuarial ruin." It's important to realize that once you start drawing down your principal, you run the risk of actuarial ruin -- and the more principal you withdraw, the greater this risk.

You can find a lot of research, analyses, and opinions on actuarial ruin in the reams of financial literature out there. Prominent in this literature is the four-percent rule, which goes like this: Invest in a balanced portfolio of stocks and bonds. In your first year, withdraw four percent of your portfolio, and give yourself increases for inflation each year thereafter. According to advocates of the four-percent rule, you'll have a low likelihood of outliving your money, and you'll enjoy a retirement income that's adjusted for inflation.

The four-percent rule got its start with a landmark paper published in 1994 by William Bengen. He used a historical approach, examining how various withdrawal and asset allocation strategies would have worked in the past, given actual history regarding investment and inflation. Here are some key details on his approach:

  • He looked at drawdown percentages ranging from one to eight percent.
  • He analyzed five different portfolios, ranging from an asset allocation of 100 percent government bonds to 100 percent stocks.
  • He examined all retirement periods that started on January 1 of each year, beginning in 1926. In other words, he detailed what would have happened if you had retired on January 1, 1926, on January 1, 1927, and so on.
  • He then calculated how long your retirement savings would have lasted under all these scenarios.
Here are some of Bengen's important conclusions:
  • A three and a half percent withdrawal rate lasted at least 50 years under all scenarios and all retirement periods, leading to the absolutely safest withdrawal rate.
  • A four percent withdrawal rate, coupled with a portfolio consisting of 50 percent stocks and 50 percent bonds, in the worst case exhausted the retirement savings in 33 years, and in most cases lasted 50 years or more. Thus was his reasoning behind the four-percent rule.
  • The 50/50 asset allocation produced the minimum likelihood of actuarial ruin. But a portfolio with 75 percent stocks had only slightly higher risks of actuarial ruin, and the significant investment in stocks usually produced higher wealth accumulations -- which could be used for legacies to children and charities -- than the 50/50 portfolio. Allocations to stocks of less than 50 percent and greater than 75 percent were counterproductive, according to Bengen.
  • The worst scenarios developed when significant "events" happened early in retirement -- events such as a large stock market downturn and/or high inflation. Portfolios were so depressed that it was difficult for them to recover. Retirements starting in the 1970s represented this worst-case scenario.
We've experienced a few important events and trends since Bengen published his paper in 1994. For one thing, the stock market and economy have melted down twice. And people are now expecting to work beyond age 65, so you may not be retired for 30 years or more -- unless, of course, you take care of your health. Then there's a good chance you might live beyond age 95, particularly if you're a woman.

Bengen's original paper did not take into account such real-life factors such as taxes and investment expenses. Since Bengen published his paper 16 years ago, there have been various critiques of his approach, reflecting the limitations, events, and trends mentioned above, as well as a significant paper published earlier this year that updates and refines his method. Bengen himself has published updates to his methods. And there are methods other than Bengen's historical approach to determining drawdown amounts. My next post will examine these refinements and alternatives to Bengen's approach as we continue to analyze the four-percent rule.

But I don't want to leave you hanging too much, so let me just say this: I believe the four-percent rule is a good starting point for your investigation of the appropriate withdrawal amount that best meets your circumstances. But life is just too complex, and individual circumstances vary too much, to boil things down to a simplistic rule that works for everybody. Bengen's original paper even acknowledges this observation and discusses how you would use his analyses to determine your specific withdrawal percentage and asset allocation.

There are variations and modifications of the four-percent rule that might work better for you, and I highly recommend that you learn about these before adopting your withdrawal strategy. Stay tuned!

More on CBS MoneyWatch
IRAs and 401k: 3 Ways to Generate Lifetime Retirement Income
IRAs and 401k: Generate Retirement Income with Just Income and Dividends
IRAs and 401ks: Maximize Retirement Income with Immediate Annuities
IRA and 401k: How to Generate Retirement Income with Managed Payouts