Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com
Planning for retirement is a tricky thing. Savers face a slew of uncertainties and unknowns. Some will save too little, while others will save too much.
The retirement problem attracted the attention of computer science professor Étienne Gagnon at the University of Quebec at Montreal. He developed an approach in 2013 to withdrawing your savings over the course of your retirement and shared his results online at the Financial Wisdom Forum and Bogleheads.
Prof. Gagnon first considered the popular 4-per-cent retirement rule, developed in the United States by financial adviser William Bengen, and concluded it was too miserly. Mr. Bengen found that retirees were unlikely to exhaust a balanced portfolio if they set a 4-per-cent withdrawal rate at retirement and then increased it to track inflation each year thereafter.
What you need to know about saving for retirement – and building a financially secure future
Investors who employed the rule made it through some very bad historical periods, including the inflationary 1970s. But, in happier times, they would have spent too little on themselves while accumulating vast riches.
Prof. Gagnon prefers his own “variable percentage withdrawal” method instead. The basic idea is to figure out how much to take out of a portfolio over a set number of years, assuming long-term historical growth rates for a particular asset mix. The amount taken out each year varies both as the value of the portfolio changes and as the retiree gets older.
While using the approach is a little more complicated than the 4-per-cent rule, Prof. Gagnon helps by providing step-by-step instructions and a handy lookup table on the method’s homepage. The more technically minded will also enjoy his planning and back-testing spreadsheets.
While the approach typically suggests withdrawal rates of more than 4 per cent for retirees, it does so at a potential cost. Problem is, there is a good chance the dollar amount taken out of a portfolio will temporarily fall (in inflation-adjusted terms) at some point during retirement. Belt-tightening would have been required during some of the big crashes of the past.
Prof. Gagnon suggests a split solution to the problem. He thinks investors should try to cover their basic needs with income from stable sources such as pensions, old age benefits and the like. If those sources don’t cover the bare necessities, they can be bolstered with annuities. The rest of the portfolio can then be used to fund spending that can be temporarily reduced or postponed, such as travel, entertainment and other discretionary items.
You can get a sense of the risks involved by using his historical back-testing spreadsheet. For instance, I looked at the experience of a U.S. investor who started their retirement in 1955 with a $1-million portfolio that was split equally between U.S. stocks and bonds over a 35-year retirement horizon.
The investor had a good time of things until the 1970s when their annual withdrawals fell from an inflation-adjusted high near US$65,000 to a temporary low near US$32,000. Over all, they took out an average of about US$50,000 a year over the 35 years. (All of the returns herein are in U.S. dollars, but Canadian back-testing is also available from 1970 through 2019.)
By way of comparison, the 4-per-cent rule would have generated flat real annual withdrawals of US$40,000. The variable percentage withdrawal method provided higher spending levels overall at the cost of a few lean years along the way.
I encourage you to play with the spreadsheet to get a better sense of the market’s historical downside risk. You’ll find the 4-per-cent rule is often far too parsimonious.
Perfect planning is beyond even the best of us, but Prof. Gagon’s approach should allow investors to enjoy richer retirements while curbing risks. With a little luck, they’ll live long happy lives and none of them will wind up being interred as the richest corpse in the graveyard.