‘4% rule’ can be iffy for retirement withdrawals

Dear Liz: I am confused about “safe withdrawal rates” from retirement accounts. I’ve read that withdrawing 4 percent of savings each year is the gold standard that financial planners utilize to ensure that life savings are preserved in retirement. However, if the Standard & Poor’s 500 index returns on average 8 percent a year, and if the life savings are locked down in a mutual fund that is indexed to the S&P 500, then shouldn’t the annual withdrawal amount, to preserve those savings, be 8 percent? Limiting my withdrawals to 4 percent means my retirement would be pushed several years down the road. Can you clarify?

It’s good you asked this question before you retired, rather than afterward when it might have been too late.

You’re right that on average, the S&P 500 has returned at least 8 percent annualized returns in every rolling 30-year period since 1926. (“Rolling” means each 30-year period starting in 1926, then 1927, then 1928 and so on.)

But the market doesn’t return 8 percent each and every year. Some years are up a lot more. And some are down — way down. In 2008, for example, the S&P 500 lost about 37 percent of its value in a single year.

Such big downturns are especially risky for retirees, because retirees are drawing money from a shrinking pool of assets. The money they withdraw doesn’t have the chance to benefit from the inevitable rebound when stock prices recover. Bad markets, particularly at the beginning of someone’s retirement, can dramatically increase the odds of running out of money.

Inflation also can vary, as can returns on cash and bonds. All these factors play a role in how long a pot of money can be expected to last. The “4 percent rule” resulted from research by financial planner William Bengen, who in the 1990s examined historical returns from 1926 to 1976. Bengen found there was no period when an initial 4 percent withdrawal, adjusted each year afterward for inflation, would have exhausted a diversified investment portfolio of stocks and bonds in less than 33 years.

Some subsequent research has suggested a 3 percent initial withdrawal rate might be better, especially for early retirees or those with more conservative, bond-heavy portfolios.

Free online calculators can give you some idea of whether you’re on track to retire. A good one to check out is T. Rowe Price’s retirement income calculator. But you’d be smart to run your findings past a fee-only financial planner as well. The decisions you make in the years around retirement are often irreversible, and what you don’t know can hurt you.

Dear Liz: After many years of unemployment, I finally got a full-time position. It is a state job with a pension. How much do I need to save for retirement? Can I focus on paying off debt and saving for college and trust I will be OK in retirement?

Your long stint of unemployment should have taught you that no job, and no plan for your life, is guaranteed.

You may have to work for the state for years to become “vested” in the plan, or eligible for a retirement check. In order to actually retire, you typically have to stay employed by the state for a decade or more. Even then, your check in retirement may not replace a big chunk of your salary. Traditional defined benefit pensions tend to offer the highest benefits to those who work for the system for decades.

A lot can happen while you’re waiting for your pension to build. You could get fired or laid off or suffer a disability that limits your ability to work. The pension plan itself could change.

If your employer doesn’t pay into the Social Security system, that adds another layer of uncertainty to your future. You could wind up without a pension, or only a small pension, and less Social Security than you might have had with a job that did pay Social Security taxes.

That’s why it’s essential to save for retirement even with the prospect of a good pension. You may be offered a tax-deferred workplace plan, or you can save on your own through IRAs or taxable accounts.