Last Updated Jan 23, 2011 6:51 PM EST
How much can you safely spend each year from your nest egg? The answer depends more on you than it does on market returns.
Now that the markets have recovered and a low cost portfolio is setting all time highs, we can again visit the subject of spending down your portfolio in retirement. What's a safe spend rate? Like most things in finance, the answer is that it depends. The biggest determinant in answering that question, however, is not market returns, but rather your control over expenses and emotions.
Returns and volatility
Any model of forecasted spend rates depends on returns and how volatile those returns are. I'm one of those that think real returns may be lower than historic returns. I suspect stocks will beat inflation by an average of about five percent annually, and bonds will yield about a two percent real return.
Taking the numbers above, a portfolio of 50 percent stocks and 50 percent bonds will produce an average annual return of roughly 3.5 percent annually. Of course, that return will come in years like 2008, where it lost 16.1 percent, or years like 2009, where it gained 17.7 percent.
Measured in standard deviation, I estimate that this fifty-fifty portfolio will have a volatility of ten percent. Put in English, this portfolio with an expected 3.5 percent real return and 10 percent standard deviation means that, in 19 of every 20 years, the portfolio return will be between a real negative 17.5 percent and a positive 23.5 percent. Yes, markets are risky.
So how much can you safely spend?
How much you can spend depends partially on market returns and partially, but even more importantly, on your behavior. I crunched the numbers above into a Monte Carlo simulation model to see how much one can spend for 25 years with an 80 percent success rate. I model in real, inflation adjusted returns, since I want the client to be able to keep up their standard of living. The answer supports "the four percent rule."
This means that, for every $100,000 in your portfolio, you can spend $4,000 this year. If inflation runs three percent a year, you can spend $4,120 next year, $4,244 the following year, etc.
Back to reality - expenses
The first problem with this four percent rule is that it ignores expenses. We can build a low cost portfolio using the Vanguard Total Stock Market Fund (VTI), FTSE All-World Ex-US (VEU), and Total Bond fund (BND) and produce an average cost of 0.13 percent annually. That doesn't have too much of an impact on the four percent rule, as it only lowers the spend rate to 3.9 percent annually.
The average portfolio, however, has an approximately two percent expense load. This translates to roughly a 1.25 percent expense ratio, and about 0.75 percent in hidden costs such as trading costs and soft costs that aren't included in those ratios. So factoring in expenses lowers the safe spend rate to 3.1 percent annually.
Back to reality -emotions
Still not done with the bad news. The inescapable reality is that investors, as human beings, are programmed to buy high, sell low, and chase performance through every bull and bear market that comes along. My research shows that the cost of this programming to the average investor is underperforming markets by an additional 1.5 percentage points. If you think using a professional advisor will avoid this performance chasing, data shows that advisors may actually be even worse market timers. This lowers your safe spend rate to only 2.6 percent, meaning you only have $2,600 to spend in the first year.
Good and bad news
The good news is that the old four percent rule is actually valid. There is even more good news in that you are mostly in control of whether or not you can achieve the necessary returns to support this spend rate.
That said, you are human and prone to making investment mistakes. Think you are invulnerable to having your head turned by that next hot money manager? Who else remembers how invincible Bill Miller was a few years ago after more than a decade of "beating the market?" And wasn't it just yesterday that our stocks were getting creamed in 2009, and the prospect of rebalancing and buying more stocks seemed about as appealing as getting dental work done without anesthesia?
The four percent rule is based in academia rather than reality. However, if you can avoid the penalties from expenses and emotions, it's in reach. Though if you are the average investor, you might want to cut that four percent down to 2.6 percent.