The Smart Take:
You’ve perhaps heard the 4 percent rule, that if you take 4% out of your investment account each year, you’ll never outlive your money. Kevin talks about where this idea came from, and pokes some holes in this strategy in this third installment of Rules Gone Awry.
This is the fourth of a five-part series we’re revisiting on Retirement Rules Gone Awry.
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Introduction: Welcome to Retire Smarter with Kevin Kroskey. Find answers to your toughest questions and get educated about the financial world. It’s time to Retire Smarter.
Walter Storholt: Thanks for being here for another edition of Retire Smarter. I’m Walter Storholt alongside Kevin Kroskey, President and Wealth Advisor at True Wealth Design. Serving you throughout Northeast Ohio with offices in Akron and Canfield.
Walter Storholt: You can find them online TrueWealthDesign.com that’s TrueWealthDesign.com. Kevin, great to speak with you this week. How are you, sir?
Kevin Kroskey: Oh, you too, Walter. I am a little chilly, a little chilly. We’re about a week before Halloween and our September weather has gone. We’re well into October and it’s been a cold one if that. So particularly being a bald man, you tend to feel these things a little bit more than others.
Walter Storholt: As we record the show. Here in late October. We certainly have turned that corner, no doubt about it. Now from kind of that summertime into the fall, it happened very quickly though this year for me. Kevin, I don’t know if you felt the same way, but it was just like shorts and a tee shirt one day and then like winter coat the next day. There was no in-between.
Kevin Kroskey: Absolutely. So, my five-year-old daughter did just asked the other day, daddy, when’s he going to start snowing? And I think she saw the immediate reaction on my face like what did I say wrong?
Walter Storholt: So we can blame her. She jinxed it, right? Well, hopefully, we won’t have to contend with too rough of a winter, although I’m a lover of snow so I never wish against the snow. But I’m one of those weird people I guess. But in any event, maybe one of these podcasts, soon we’ll be recording as there’s, you know, snow falling outside. We’ll be chuckling about that. I’m sure. Well, we’re in the midst of a series talking about Retirement Rules Gone Awry. Some of these things that have been long believed in the financial world and the financial landscape that really shouldn’t necessarily be subscribed to that may have some holes in them or some problems. And there is a big one, Kevin, that we’re tackling today. If you saw the headline of the show, you’ll see that it’s the 4% rule. This thing’s been around for a long time, but I understand that we need to kind of poke it with spearS&Poke lots of holes in this theory.
Kevin Kroskey: Yeah, so we should probably define it. I mean it probably is ringing bells for a lot of people. It’s probably one of the most widely known retirement rules that are out there. But simply stated, it’s, you know, how much can you pull out from your investment account each year safely and make sure that you don’t run out of money. So they put that in context. There’s a guy by the name of Bill Bengen who was a practitioner in the industry and lived out in California and he did this study in the early nineties and he actually was a career changer. So he came out of a family business that was sold and got into financial planning. And one of the things that he found when he came over into the industry was there was a lot of information about investing money and accumulating money, but there was very little about spending money in the kind of, you know, decumulating it from a portfolio.
Kevin Kroskey: So what Bill did was took historical returns for the US all the way back to 1926 and you looked at a 30 year period. So somebody retires in 1926 starts taking money out of the account, and each year that they live throughout retirement, they take inflation increase. So in 1927 for example, let’s say that inflation was 3% over the year prior, so they will go ahead and take out a 3% raise in 1927 so on and so forth. And basically what Bill found in doing that was that the absolute worst case, not the best case, not the average, but the worst case that somebody was able to do was about 4% you know, taking, just put some dollars on it. Say you started retirement at $1 million, you can take 4% or $40,000 out in year one of retirement, increased that by the actual inflation rate each year over a 30-year retirement life span and still be okay.
Walter Storholt: So why did this thing, you know, pickups so much popularity as a rule for many, many years. I mean, what got this to kind of be the gold standard?
Kevin Kroskey: I think it was more, I don’t know, gold standard, and we’ll kind of talk about some evolutions and talk about the current environment today, but it was really more of a seminal work where there was really not that much if anything before. So the fact that he was looking at it, and you kind of got to put this in context as well, so you know, in 1992 interest rates were still quite high. You know, people could go ahead and leave money at the bank and get near double-digit rates of return on their savings. People were really starting to live longer, so life expectancy was increasing quite rapidly. People still have pensions that were in retirement, although that was, you know, starting to change as some of those were going away or becoming frozen.
Kevin Kroskey: And certainly that is accelerated over the last couple of decades. But you know, retirement planning was a lot easier if you go back a generation. And I’d speculate that’s maybe some of the reason why the decumulation or spending from an investment account wasn’t really on the radar and in the, you know, investment and financial planning literature. But Bill really kind of started that in the early nineties. So today, when you don’t have these traditional defined benefit pensions, at least not nearly to the extent that they did a generation ago, and you have interest rates that are, you know, near historic low and people, are living a lot longer, how much you can spend from your portfolio is so very important today compared to what it was a generation ago.
Walter Storholt: As we were talking about this 4% rule. What are some of the major problems in and that we’ve kind of got this clear definition of this thing? What are some of the major problems you talk about the evolution of it? Why has it gone through so many evolutions and changes and now maybe not as held in high esteem?
Kevin Kroskey: Well, I will go there in a second. Let me back up for a moment because one of the things that some people may be thinking about right now is 4% what do you mean 4% I mean if on average I’m going to earn more than that, why can I only spend 4%? So I’m sure there’s probably a fair amount of people that are going to listen to this and think that. So say if you’re on average going to get 6% per year, why can’t you spend 4%? You kind of leave two in the kitty and have it keep growing. Well, if you think about it, simplistically, you know, returns are volatile, call it a wiggle factor, if you will.
Kevin Kroskey: Interest rates have a relatively low wiggle factor. You know, they certainly move around, but it’s not like you’re going to get, you know, really wild swings in interest rates. Say going from like plus 20% to minus 20% or something like that. However, that wiggle factor is much more severe when it comes to stocks. And you know, you go back to 2008 and stocks were down by about 40% and in really nearly north of 50% from a peak to trough decline. And you can have years, even just a few years ago, you know, US stocks were up north of 30% and in small company stocks, we’re north of 40%. So if you think of those in terms of, you know, a goalpost runway, the runway is a lot wider for stocks than it is for bonds. And that’s in the short term. But even if you go out over the longer term, you know that runway for stocks will narrow. I pulled up some data in front of me. I have kind of a best and worst 20-year return for the S&P 500 and this goes back all the way from 1926 when really good market data began to come about through the end of 2017. So Walter, if I’ll put you on the spot here, you have any guess what the best 20-year return was for the S&P 500.
Walter Storholt: The best 20-year return for the S&P 500. That’s a pretty long period of time. So I would say it’s not maybe as high as you would think. Let’s go 10% I’ll just, I’ll just guess 10%.
Kevin Kroskey: So 10% is about the average, if you go all the way back to 1926 in fact, with some of the favorable returns that we’ve had over the last several years for the US stock market, it’s actually 11% so S&P 500 1926 through 2017 annual compounded average return is 11% the best is north of 18%. 1-8, quite high. And that’s 1980. You know, going on forward. So conversely, Oh, give you a chance of redemption here, Walter. What was the worst 20-year return?
Walter Storholt: I feel good that I hit the average on the head it sounds like. But let’s see, I would say that wasn’t your question though. Unfortunately. The worst
Walter Storholt: 20 and we’re going 20 years span again?
Kevin Kroskey: We are.
Kevin Kroskey: Well, I was 8% off on my 10% guess. I’ll go 8% off on my low guess since I was right near the average. How about 2%?
Kevin Kroskey: You? Wow. I’m quite impressed. Nice recovery. It’s actually 1.89% I’ll round it up to 2% and say you’re a winner.
Walter Storholt: Redemption. All right. I was really good. At “The Price is Right” games growing up whenever I was sick, you know, and you’d stay home. The one thing about being sick and staying home from school is you got to watch “The Price is Right.” I don’t know if I’m the only one that felt that way, but I was always really good at “The Price is Right” games, so I feel like I’d be a good contestant there. This proves it.
Kevin Kroskey: When you think about that runway. So the average is 11% and this is over a 20-year time span. So we’re not talking about minus 40% to a plus 40% you know that runway is quite wide, but even over 20 years we’re gone from, just call it 2% to 18% so the runway from a one-year perspective historically is about, you know, if it’s minus 40% to plus 40% again, I’m just kind of using some ballpark numbers here, but you know, that’s 80% you take both sides of those and add it up over 20 years.
Kevin Kroskey: That 80% narrows down to a 16% differential. But it’s still quite a big differential and we’re talking over 20 years. So if I just do some kind of simple math in my head, if we’re talking about a 16% difference over 10 years, 16 times 10 is 160% difference, double that to get to 20 years, we’re talking 320% difference in cumulative return. And that ignores compounding. With compounding, it’s going to be quite more, so to loop this back into the 4% rule, what Bengen was doing was saying, Hey, you know, returns are variable. You know, even if we can get an average return of say 6% or 8% or whatever it may be, we’re not going to be able to spend that average because there’s this risk that we get a negative sequence of returns at the outset of retirement. A lot of the researchers, we’ll call this return sequence risk, I’ve kind of adopted a simpler nomenclature called bad timing risk.
Kevin Kroskey: You don’t know when it’s going to manifest. You know you don’t know if your retirement is going to cause the US market to go into a big decline like it did in 2008 but you have to be able to plan for it and you don’t want to have to retire and then unretire and go back to work. So you know, this whole idea of what you can spend safely from the investment portfolio is incredibly critical. And it’s why also at first glance where the returns on average you’re going to be 6% or 8%. Once you factor in the volatility or that wiggle factor that I talked about, the safe spending rate is something that’s historically speaking going to be a lot less.
Walter Storholt: So the amount you withdraw obviously matters, but also the timing of your withdrawals is a big part of this equation is a big factor that goes into that. And I think that’s really interesting, you know, to notice and to realize. So let me ask the obvious question, Kevin. If 4% isn’t the right answer, what is?
Kevin Kroskey: Well, it’s another one of these rules where I think the research that Bengan did was a good base case. And you know, there are some people, if people have been listening to this whole series, this is kind of like the one that we did previously about, you know, spend 80% of your preretirement income in retirement. It may match up for a small segment of the population. Certainly, the more means that you, the less likely it is to match up. And the same two goes here with the spending rate as well. So when you look at this and say, well, you know, Hey, does it apply? Is it a good rule? What have you, when I think about the clients that we serve on a daily basis, again there’s probably only about a handful or so that it really applies to.
Kevin Kroskey: So if you have somebody that is retiring, you know, in the early sixties say 60 years old and maybe they don’t have a pension, so they retire at 60 they’ve done well and now they have to go and replace their paycheck. So you know, they can’t take their Social Security yet. Earliest, that’s 62, and as we talked about in a prior episode, that may not necessarily be a good age to go ahead and take your benefits. But if you’re 60 your portfolio has to do all the work. If you don’t have any pension, and if you don’t have any Social Security or other retirement income coming in, so your distribution rate or your spending rate is going to be, you know, going to be way higher. More likely than not than 4% and if you’re going ahead and if you’re doing a Social Security deferrals strategy as well, which again, there’s a lot of merits that go into a strategy like that for many, many people, but the portfolio is going to have to do more work for an even longer period of time.
Kevin Kroskey: It’s not uncommon that we have distribution plans for our clients where they’re spending, you know, 10% of their portfolio in the early years of retirement. However, when they get into their seventies and say the maximum Social Security benefit kicks in, their spending rate may only be like 1% or 2% I can think of a couple of handfuls of clients where literally their spending rate is going to go down to basically zero and they may actually be saving more money if they don’t change their spending behaviors and increase them from what they were before. So there’s going to be things that change for everybody, you know, whether it’s a Social Security deferral or whether your just your expenses in general, you know, that’s another thing again, that 80% rule, it doesn’t really apply. You know, most people have some expenses that are going to be consistent at the beginning of retirement and will increase with inflation as long as they live. Other expenses.
Kevin Kroskey: When you look at actual retiree spending, data go down over time. So to go back without kind of hashing out the entirety of a prior podcast about the 80% rule, but simplistically the sixties tend to be the Go-go years, the seventies tend to be the slow-go years and the eighties tend to be no-go years. And as you go through those different decades and those behavioral changes, your spending really does decrease in terms of what we call real spending or after inflation. Or said another way. If you just spent the same amount of money, say it was you know, $70,000 that you were living on at age 60 and you just had $70,000 for the next couple of decades because you’re spending on average is going to go ahead and decline in some of those categories are just going to fall off. Then that’s $70,000 even though it’s not keeping up with inflation, it’s probably going to approximate the change that you’re going to have in your spending behaviors given the go-go slow-go and no-go phase.
Walter Storholt: Well that’s always nice. We talked so much in percentages Kevin, but it’s nice when we can actually put dollar figures to some of these conversations as well. I’m just curious if you’ve got maybe an example of a story you can share with us about somebody who you made a tangible dollar difference in the plan that you put together versus if they had done some sort of plan, like the 4% rule, kind of what their situation would have been. You know, had certain circumstances happened versus having a plan put in place that you know, you and your team were able to design?
Kevin Kroskey: Yeah, I can. So, if I just start with Social Security, for example, I’ve measured concretely for clients where, Hey, here’s your current thinking. If you go ahead and defer, you know, say one of the spouses Social Security benefits, usually the higher of the two and, we go through and kind of stress test both plans at different spending rates. And in effect, we kind of want to get a similar result at the end of the plan. How much more spending can say a Social Security deferral strategy allow you to do on a similar basis. And I’ve measured where it’s been as much as say like $6,000 or $7,000 a year for certain clients. And that’s just Social Security. So when you get into the distribution plan, we haven’t spoken about taxes yet. Whenever Bengen looked at this in the early nineties the 4% rule corresponds to basically the money not being taxed.
Kevin Kroskey: So if the money is coming out of an IRA and say your average effective tax rate is maybe 10% or so, so it’s going to be something less than that you’re going to be able to spend on an after-tax basis. And if that money is not in an IRA, but in say like a brokerage account or a trust account or a joint account with your spouse, there’s going to be some tax drag on that because you’re going to get a 1099 every January and that’s going to have to show up on your tax return. So once you start getting into not only the distribution plan and matching that to spending, but overlaying that with some smart tax strategies, it’s easy to see and run simulations where you can show somebody that, Hey, you know, here’s the way you were thinking about doing it, or the way that most people do it, kind of these roles that you have.
Kevin Kroskey: But if you do it this way, your spending is going to last maybe an extra three or four years. So you can kind of equate it to how much more can you spend per year on a similar sort of safe basis. You can translate it to how many more years would your money last? Or you can also translate it to, you know, kind of a quest value and say how much more money are you likely to have when we like to say your plan ends, which is a very PC way of saying you kind of move on or pass away. So you know, depending on what’s important to the person, we can kind of gauge that for anybody and start quantifying some of those benefits. And the good thing is too, Bengen really kind of started this in 1992 there have been so many good distribution planning articles that have come out and particularly as interest rates have gotten a lot lower and as stock values have gotten a lot higher or there’s been a lot more attention being paid to this area. So there’s a lot of good work that’s been out there, peer-reviewed by a lot of smart people, quantifying the benefits of these different distribution strategies. And the good thing for us is, you know, we may not be original and kind of creating this work, but we can certainly read it, comprehend it, explain it to clients and simple language, and then incorporate it in their plan to make better, smarter decisions for them in their retirement.
Walter Storholt: It’s another one of those Retirement Rules Gone Awry. The 4% rule where you withdraw 4% each year from your retirement plan and it kind of says, Hey, you’re going to be all right if you do it that way. Plenty of holes poked into that theory today. Kevin, before we wrap up the conversation, anything else you want to highlight about the 4% rule that you think would be important to know?
Kevin Kroskey: You know, it’s a starting point. People that are reading about it, it gets you thinking about it, but it really is just a starting point. You know, there’s a lot of value that a good advisor can add. If they can go ahead and actually take a lot of this research, simplify it, give you the clarity and confidence to go ahead and make better decisions and show you those tangible benefits that it will make. Whether that’s retiring early, making your money last longer, leaving more to your kids or to the charities that you support or you know, Hey, be a little bit fun and a little bit selfish and spend more money while you’re living, you know, see the benefits of having those experiences for yourself, for your family. Maybe even giving some of the money to your kids while you’re alive rather than just waiting and giving them a big lump sum while you’re gone. So all this stuff is interrelated. That should be becoming very, very clear if you’re listening to this Retirement Rules Gone Awry, podcast series that we’ve been doing, but if you’re missing a piece of it, it’s kind of a domino effect as well. So he kind of needs to look at everything if you’re really going to get the most out of what you have.
Walter Storholt: I like the way that you described that and that’s definitely a common thread between all our Retirement Rules Gone Awry. They probably should be renamed instead of retirement rules to possible starting points for the conversation. Likely not to be where you end up.
Kevin Kroskey: Right. That’s not as catchy as a Retirement Rules Gone Awry. I’m open for suggestions here that I think I may have said earlier, that’s my working title for this book that I’m writing. However, it’s got to be catchy. I’ve been told, so starting place, probably not a good title. Retirement Rules maybe, I’m not sure, but if anybody has a good suggestion, go ahead and reach out to us for that. Or you know, if you have questions about this in general, you know, we’re happy to help there as well.
Walter Storholt: If you have questions about your financial plan or about any of the Retirement Rules Gone Awry that we’ve talked about on the recent podcasts, you can give Kevin and the team a, call at True Wealth Design. It’s (855) TWD-PLAN. That’s it. (855) TWD-PLAN If you’d like the full number version. That’s (855) 893-7526 and always online at TrueWealthDesign.com if you’d like to get in touch with the team through the website, you can click on “are we right for you” button right there when you go to the website, TrueWealthDesign.com and you can schedule a 15-minute call with an experienced financial advisor on the True Wealth team to see if you would be a good fit and if you need some financial planning assistance, TrueWealthDesign.com or give a call (855) TWD-PLAN. We’re not quite done with the Retirement Rules Gone Awry series.
Walter Storholt: We’ll tackle another issue coming up on the next podcast. Don’t forget to subscribe to Apple podcast, Google podcast, and everywhere else you can find podcasts and where you’d like to subscribe to them. Don’t forget to look us up, Retire Smarter, so you don’t miss an episode. Kevin, thanks for all the help and we’ll look forward to another conversation next time around it.
Kevin Kroskey: Sounds good, Walter. Thank you.
Walter Storholt: For Kevin Kroskey, I’m Walter Storholt. We’ll talk to you next time on Retire Smarter.
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