A recent survey by the Westport, Conn.-based MetLife Mature Market Institute indicated that 43% of baby boomers believed they could take distributions of 10% or more from their portfolios in retirement and still live the life to which they had become accustomed. At the same time, some in the financial services industry act as if anything above 4% is foolish. Well, they are both wrong.
The reality is, history provides us with a reasonable guide for determining the “likely range” of distribution rates investors can expect from a balanced and diversified portfolio throughout their retirement years.
Looking back over the last 100 years, it is clear that financial markets can move in extreme cycles. We have had severe declines during the Great Depression and the bear markets of the 1970s and 2000s but also experienced amazing growth during the bull markets of the 1920s, 1950s and 1990s.
When you analyze all of these good and bad cycles from a retirement income standpoint, you find that a hypothetical 4% inflation-adjusted distribution had a success rate of over 95% for every 30-year period, starting in 1926.
Thus we have a rational basis for determining that 4% is the likely minimum safe distribution rate for retirement income portfolios. Safe, however, does not mean guaranteed. There have been a few historical cycles (depending on how you run the simulations) that would not have supported 4%, and we may experience other such cycles in the future. But we must make a decision in the face of all this uncertainty, and 4% is supported by the historical research. We could say 2% to be really sure, but that rate is so low that it fails to provide investors with any meaningful insight.
If 4% is the low end, what is the likely upper end? Here again, historical data is very helpful. Because historical cycles can produce wildly different results, if investors stuck with the 4% rate, many would have left a lot of money on the table. For instance, assume that an investor retired in 1950 with a $1 million portfolio and used the 4% inflation-adjusted rate for the next 30 years. At the end of that cycle, the portfolio would have been worth over $5.5 million. Clearly, this retiree could have taken out much more than 4% and not put himself at any significant risk of running out of money.
When we analyze the historical figures, we get a pretty good sense of what happens to the risk of portfolio depletion as the distribution rates rise above 4%. At a 5% inflation-adjusted distribution, the historical portfolio failure rate jumps to about 30%. At 6%, the failure rate hits 50%, and at 7%, the failure rate is over 70%.
Given this historical data, we can summarize that a “likely range” of inflation-adjusted distributions is between 4% and 6%. Good market cycles may support up to 6%, but poor market cycles probably won’t support more than 4%.
This means that if clients are in a position to live on a 4% distribution, then they have a ticket to the retirement game. If they cannot live on 4%, then they are probably not ready to retire.
We have to be careful, however, not to discourage investors when we talk about their potential retirement income. While 4% may be necessary at times, the numbers indicate that many retires can anticipate that their distributions may reach 5% to 6% depending on market performance.
For instance, it is possible that a client’s initial 10 years of retirement might support only 4% because of a bear market, but the next 15 years might support 6% thanks to a bull market. It is our job as advisors to help clients understand when they need to scale back to 4% and when it may be prudent to reach for more.
The focus of our discussion with clients should be to help them understand the probable range of distributions they may expect during their retirement years. Today, it is fair to say that 4% to 6% is a good estimate.
