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Wednesday, May 16, 2012

Making the Nest Egg Last - Bengen

Seniors consistently say that running out of money is their greatest fear in retirement.  It's not surprising, then, that there has been considerable research on the appropriate nest egg paydown rate.  Bill Bengen set the ball rolling in this area when he published a series of papers in 1993 that looked at 30-year periods going back to 1926 (before the Great Depression) and analyzed payout rates.  He found that over the 38 thirty-year periods, a 4% paydown rate, adjusted for inflation, lasted for all but one 30-year period. 

This was the genesis of the 4% paydown rule that is widely used today.  Further study raised the rate to 4.5%.

To be clear on this rule, it works as follows.  If you retire today with a $1 million IRA (he assumed a tax deferred portfolio), you can take out $45,000 this year.  Next year, assuming inflation is 2%, you can withdraw $45,900 ($45,000 * 1.02) and so forth.

Clearly this is not an easy problem.  There are several important unknowns that raise their ugly heads-- including the rate of inflation, market returns, and how long a person will live.  Bengen assumed an asset allocation of 35% large cap stocks, 18% small-cap stocks, and 47% intermediate government bonds.

So what was the 30-year period that failed and why did it fail?  Surprisingly, it was the period when a person retired on 1/1/1969.  This is surprising because this period ended with the greatest bull market in the history of the stock market.  So, what was the culprit?  Inflation!

Updated Research

Bengen has revisited the payout problem in "How Much Is Enough?" in the May 2012 Financial Advisor magazine and examined additional periods.  In the exceptionally clear article, he furthered his research by comparing the first 12 years of 1969 to the period beginning on 1/1/2012.  This latter period, of course, has experienced 2 severe market downturns.  Bengen wanted to know if the 1/2000 was on a course for failure - a question facing many retirees today.  Furthermore, he suggested some steps for retirees in situations where the initial, crucial years of retirement are not very friendly in terms of the market and inflation.

In analyzing market performance, he found that 1969 produced a 7.6% average annualized portfolio return over the first 12 years compared to 5.4%  for the corresponding period beginning on 1/1/2000. Still, Bengen finds that the 2000 retiree is in much better shape because of inflation.  As the years  move along, the current withdrawal rate will be influenced by inflation.  Thus, in year 5, for example, the amount taken will depend on the prior 4 years' inflation.

Over the first 12 years beginning on 1/1969, inflation averaged 7.8% compared to 2.5% for the 1/2000 retiree!

Bengen captures the impact by tracking the "current withdrawal rate."  He finds that, at the end of the 12-year period, the failed 1969 withdrawal strategy had a current withdrawal rate of 12.5% (3x the initial 4.5%!) compared to 5.9% fot the 2000 retiree.

His findings emphasize the importance of staying focused on inflation.  We have come through a period of very modest inflation which naturally tends to cause people to lose sight of its potential significance.  Furthermore, many observers foresee the possibility of a sharp pick-up in inflation sometime in the next several years due to the monetary policies designed to pull global markets out of a severe slowdown.  This is something that retirees need to keep on the radar screen.

Bengen points out that, if the retiree senses the possibility of a failure, he or she can either reduce spending or increase income.  He states,
Take some pre-emptive action, no matter how mild, when the current withdrawal rate first exceeds the initial (or expected) withdrawal rate by 25%.
He has 3 recommendations for increasing income:  immediate pay annuity, reverse mortgage, change investment methods (avoid overvalued assets).

I strongly urge anyone interested in this vital area for retirees and near-retirees to click the link above and read Bengen's article.  What I've given you here is a Cliffs Notes version.  The article, unlike many in financial planning magazines, is highly readable.


  1. Thanks for sharing. I will give this to my father in hopes that he might agree to start drawing down his retirement savings. He is 79 years of age. So far, he is living off a pension and SS but recently needed to borrow to cover a cash shortfall.

    1. At his age he could easily draw down 5.5% of his savings. He may want to consider a single pay immediate annuity for a portion of his savings. He could get a pretty good rate. It would convert a portion of his savings into a pension.