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The predominant retirement-financing method advocated by investment advisors, fund and ETF companies, AAII, Morningstar, and many pundits is called the “total return” approach. It has two phases:
  • The accumulation years, during which you save for retirement, targeting a nest egg whose ideal size is known as The Number.
  • The withdrawal years, when you sell off pieces of that nest egg to obtain the cash you need for living expenses during retirement.
In the second phase, there are guidelines for how much is “safe” to sell each year. The goal—“success” if you will—is to insure that you won’t run out of money while you are alive. The most common rule of thumb is the 4% rule: In the first year of retirement, sell 4% of your assets and use the cash as retirement income. In subsequent years, increment the withdrawal amount by a small percentage to cover inflation. The most common suggestion for that increment is 3% each year.
There are myriad variations on the 4% rule. Some advisors will tell you that it is safe to use 4.5% or 5% as the initial amount. Some will suggest that instead of mechanically adding 3% each year, you should vary the amount based on how your portfolio is doing, or by actual rates of inflation, or other factors. But what’s stated above—4% + 3% increment each year for inflation—is the most common baseline approach.
A Little Quiz
I am going to present a scenario and then ask a couple of questions. The idea is to see if you understand how the 4% rule works, especially the annual 3% increment for inflation. The answers are at the end of the article, but no peeking. After reading the scenario and the questions, please jot down your answers before you finish the article.
Here’s the scenario. Mr. and Mrs. Growth have saved diligently for retirement. In fact, they have put away exactly $1,000,000 by the day they both retire. They have worked with a financial advisor and avidly read the AAII Journal, and they believe they have done everything right. Their assets are correctly allocated for their age (both 65) and risk tolerance (low). Following their advisor’s recommendation, they are going to follow the 4% rule for making withdrawals from their retirement nest egg. They are planning on a 30-year retirement, and their advisor has assured them that there is a 93% chance that they will not outlive their retirement funds. They feel pretty good about those odds. They have told their kids not to expect much of an inheritance, as they plan to live long and have fun in their golden years. The kids are fine with that. They even slapped a bumper sticker on their parents’ RV that says, “I’m spending my kids’ inheritance.”
The Growths’ first withdrawal, covering Year 1, is 4% of the $1,000,000, or $40,000. That, combined with other sources of income (Mrs. Growth has a small pension, and they both receive Social Security), is enough for them to have a comfortable retirement lifestyle.
Now please answer the following questions:
Question 1: In Year 30, what amount will their withdrawal be, in dollars?
Question 2: (a) In Year 30, what percent of their (remaining) assets will they need to sell to produce the amount you gave as your answer to Question 1? (b) State your assumptions in arriving at that answer. (c) Approximately how much will remain in their nest egg after the withdrawal in Year 30 (rounded to the nearest $10,000)?
Discussion: This indeed is a total-return strategy. That means that it utilizes the natural growth of assets such as stocks to make up for the annual withdrawals. The strategy is based on the teachings of Modern Portfolio Theory (MPT). Their financial advisor used the vast modern array of financial products (especially ETFs) to construct the Growths’ overall asset allocation. He knows that the success of their withdrawal strategy depends upon getting their asset allocation right. MPT teaches that most of your returns come from your choices of asset classes, not from the particular investments you select from within those asset classes.
The 93% success rate was computed by running thousands of tests based on historical returns and variation patterns for each asset class in the Growths’ portfolio. Their advisor—who is a strong believer in safety through diversification—has put them into 21 different investments, ranging from a small stake in gold, to a year’s worth of cash, to moderate stakes in various categories of stocks, to sizable stakes in investment-grade bonds, with a little slice of junk bonds too. He articulated to the couple the reason for each selection, explaining the role that each investment plays in the overall plan. He tilted his selections to match the Growths’ conservative risk profile. In general, that means he tilted toward bonds, which are considered safer than stocks, because their principal does not vary--you get it all back at the end of the bond's term. The running of all the tests is called Monte Carlo testing, which simulates thousands of return-sequencing scenarios and tells whether the test was successful or not. “Success” is defined as not running out of money before the end of Year 30.
My Assumptions: We need a few simplifying assumptions in order to keep this article from becoming book-length. Here are the assumptions. These are also my answers to Question 2 (b) above.
  • The capital value of the nest egg (all investments combined) will expand in value at exactly the rate of inflation each year.
  • Transaction costs are ignored.
  • Taxes are ignored.
  • The rate of inflation each year is exactly 3%, matching the inflation increment built into the withdrawal scheme.
  • Each withdrawal is made at the beginning of the year.
  • The nest egg’s balance at the end of a year—after that year’s annual growth—equals its beginning balance for the next year.
I suggest that rather than skip to the end of the article right now, you take about 30 seconds to examine the following tables. There is one table for each decade of the Growths’ retirement. Try to get a feel for how the 3% inflation increment compounds. Also get a feel for how the annual growth rate expands the value of the nest egg each year.
The Results:
First Decade:
Year Number
Beginning
Balance $
Amount Withdrawn $
Percent of Assets Sold
Amount Remaining $
End Balance $
1
1,000,000
40,000
4.00
960,000
988,800
2
988,800
41,200
4.17
947,600
976,028
3
976,028
42,436
4.35
933,592
961,600
4
961,600
43,709
4.55
917,891
945,428
5
945,428
45,020
4.76
900,408
927,420
6
927,420
46,371
5.00
881,049
907,480
7
907,480
47,762
5.26
859,718
885,510
8
885,510
49,195
5.56
836,315
861,405
9
861,405
50,671
5.88
810,734
835,056
10
835,056
52,191
6.25
782,865
806,351
Second Decade:
11
806,351
53,757
6.67
725,594
775,172
12
775,172
55,370
7.14
719,802
741,396
13
741,396
57,031
7.69
684,365
704,896
14
704,896
58,742
8.33
646,154
665,539
15
665,539
60,504
9.09
605,035
623,186
16
623,186
62,319
10.00
560,867
577,693
17
577,693
64,189
11.11
513,504
528,909
18
528,909
66,115
12.50
462,794
476,678
19
476,678
68,098
14.29
408,580
420,837
20
420,837
70,141
16.67
350,696
361,217
Third Decade:
21
361,217
72,245
20.00
288,972
297,641
22
297,641
74,412
25.00
223,229
229,926
23
229,926
76,644
33.33
153,282
157,880
24
157,880
78,943
50.00
78,937
81,305
25
81,305
81,311
100.01
0
0
26
0
0
0
0
0
27
0
0
0
0
0
28
0
0
0
0
0
29
0
0
0
0
0
30
0
0
0
0
0

The Answers to the Quiz:


Question 1: In Year 30, what amount will their withdrawal be, in dollars?
Answer: There will be no withdrawal in Year 30. The nest egg went to zero in Year 25. (Had the nest egg lasted, the withdrawal in Year 30 would have been $94,262.)
Question 2: (a) In Year 30, what percent of their (remaining) assets will they need to sell to produce the amount you gave as your answer to Question 1? (b) State your assumptions in arriving at that answer. (c) Approximately how much will remain in their nest egg after the withdrawal in Year 30?
Answer: My assumptions are given in the section called “My Assumptions” earlier in the article. There is no answer to part (a) of the question itself, as the nest egg was exhausted five years earlier. The answer to part (c) is zero. There is nothing left, and it’s been that way for five years.
More Discussion:
Did you see this coming? Frankly, when I started the article, I did not. I just wanted to illustrate the surprising impact that 3% annual compounding has on the withdrawals throughout the years. I calculated the figures in the table by hand, and when I got about halfway through, I could see where it was going, and my hands started to shake. I did not want to see Mr. and Mrs. Growth run out of money. They were meant to represent real people who do everything right and follow the best advice they can find. Yet the sky falls on them anyway. Maybe you know someone like this. The speed with which their portfolio plummets to zero starting around Year 16 (when they had to withdraw 10% of their assets just to make that year’s withdrawal) is absolutely scary.
I did not deliberately set up the assumptions to insure failure. Rather, my thought was to set them up so that the plan would just squeak by. But the assumptions did, in fact, insure failure. Two assumptions did the damage. First was the assumption that the Growths’ nest egg grew at just the rate of inflation. More important was the assumption that the withdrawals were made at the beginning of the year, so the annual growth (equal to the inflation rate) was applied to the balance remaining after the withdrawal. That guaranteed that the growth, even though it equaled the inflation rate, could not in fact keep up with inflation. It always started on too low a base. The growth rate had to be higher than inflation to keep the nest egg up with inflation.
Other factors that worked in favor of the plan (ignoring fees and taxes) could not make up for the overwhelming mathematics of the compounding of the withdrawal amount. Still, the fact that the whole scheme failed by five years is pretty astonishing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Source: Retirement's 4% Rule: Surprising Answers You Need to Know About the Inflation Factor