How much do you really need for retirement anyways?
No one knew the answer until 1994, when Bill Bengen, then a financial planner in Southern California, had several clients asking him this question. He couldn’t find the answer, so he crunched the numbers. You don’t have to look too far into retirement planning before you run across the 4% “safe withdrawal rate” rule.
This means you can withdraw 4% from your retirement portfolio every year for 30 years. To figure out how much you need then, take your annual spend and multiply by 25. Example: if you spend $30,000 you need $750,000 ($30,000 x 25), or if you spend $80,000 you need $2,000,000 ($80,000 x 25).
Are you with me so far? Okay, good.
The problem with the 4% rule is that it’s, well, always changing. So I spoke with Wade Pfau, one of the top minds in retirement research. Wade earned his Ph.D. in economics from Princeton University, and today he’s a professor of retirement income at The American College, and a principal and director at McLean Asset Management.
In this interview find out why to use a “safe savings rate” for retirement planning, what mistakes to avoid when building a retirement portfolio, and where to find the latest safe withdrawal rate.
Wade, retirement income is a relatively new field. What’s the story behind how you got into it?
My interest in retirement income evolved naturally from my dissertation topic in graduate school, where I simulated the impact of President Bush’s proposals to carve out part of the Social Security program to create Personal Retirement Accounts.
I enjoy writing computer programs to create these sorts of simulations, and once I learned about the field of financial planning and retirement planning, I was hooked. There is a much closer relationship between academics and practitioners compared to economics, where I started my career. I really like being able to move more easily between theory and practice.
On the accumulation side of retirement, what are the steps someone should take to figure out how much they should be saving and investing?
I like to think about it in terms of the safe savings rate methodology I developed as a counterpart to retirement safe withdrawal rates. This involves figuring out what your retirement spending goals are, and then figuring out how much you should be saving to have sufficiently high probability for meeting those goals.
You need to think about planned retirement age, desired spending in retirement from the investment portfolio, reasonable portfolio return assumptions, and future salary until retirement. Then you can figure out how much you need to save.
What are the biggest mistakes you see people make with building a retirement portfolio, and then generating retirement income?
- Not matching asset allocation to their risk tolerance and risk capacity, which makes it difficult to stay the course in times of market stress.
- Not being willing to consider the efficiencies that can be created by pooling longevity risk with others.
- Building a completely disorganized investment portfolio piece by piece with high cost investment funds.
Sustainable spending rates depend on future market returns. Naturally, higher market returns imply higher sustainable spending rates. You can see this clearly by playing with the PMT formula in Excel.
The question is what is reasonably sustainable for retirees today, based on today’s interest rates (and one might also want to factor in overall stock market valuation levels). Also, it depends on one’s willingness to cut spending in the future if necessary.
And then there are issues like the relevant time horizon and estimated portfolio management fees. I provide somewhat regularly updated estimates for retirement spending at my Retirement Dashboard. This represents my preferred methodology for looking at these issues.
Let’s say someone who’s in their 20s wants the ability to retire by 40. What approach would you recommend to them?
You can use the safe savings rates methodology to figure it out. It will probably require a pretty high savings rate. And the sustainable withdrawal rate should be less than 4% if only because you need to plan for much longer than the 30 year time horizon implicit in the 4% rule.
You also need to assume lower than average market returns to help ensure that your plan will be sustainable, if you are using a spreadsheet to do this.
When you do your own retirement planning, what tools and resources do you use?
I’ve made my own spreadsheet to do my own personal planning. It’s based on sustaining a growing per capita household living standard for life using the principles of life-cycle finance.
It’s the same concept as Larry Kotlikoff’s E$Planner software, though I do find that software hard to use and just made my own spreadsheet. I don’t directly worry about replacement rates or withdrawal rates, because my earnings and spending are volatile over time. I just want my plan to work with a low assumed investment return assumption.
What do you think the future of retirement planning looks like?
I do think that increasingly the concept of “financial independence” will replace “retirement.” It’s not always going to be about completely leaving the labor force, but just having great control over working in exactly the way you want.
Thanks so much for the great answers Wade!