The Risk Of Outliving Their Money

For many retirees, the ideal arrangement would be to spend their last dollar on the day they die. This is not feasible, of course, because they seldom know when they will die, or exactly how long their money will last. The retiree who is determined to remain solvent to the end will very likely die with an estate that is larger than they would have chosen if they had been better informed.

The financial advisors who manage retiree funds will attempt to assuage their anxiety by readjusting their asset portfolio to reduce risk. The retiree who has been holding mostly common stock might be shifted into a portfolio that is heavily fixed-income: 75% is common, with the remaining 25% remaining in stocks.

In addition, the advisor may recommend a disciplined procedure for withdrawing funds, the most common of which is known as the 4% rule. With this rule, the retiree draws monthly stipends equal to 4% of the initial market value of his assets divided by 12, subject to annual increases in each successive year based on the inflation rate in that year.

Rob Berger provides an excellent and up to date summary of the 4% rule in Forbes, 4% Rule For Retirement Withdrawals, August 18,2022. Referring back to the evidence compiled by William Bengen, who developed the concept, Berger points out that “the 4% rule has stood up to the stock market crash of 1929, the Great Depression, World War II and the stagflation of the 1970s… an initial withdrawal rate of 4% enabled most portfolios to last 50 years or more. And for those that fell short, they still lasted about 35 years or longer, more than enough for the majority of retirees… history strongly suggests that the 4% rule is a reliable approach to determining how much one can spend in retirement.”

The weakness of these arguments is that the evidence pertains to a great variety of economic environments but nothing about the variety of retiree preferences and capacities. A rule that works for a majority of retirees but exposes a minority to destitution is not useful unless the minority know that they are exposed, can assess the risk of their exposure, and can adjust their withdrawal pattern as needed to reduce the risk to a level with which they are prepared to live.

An illustration of the kinds of data that are needed is in the table below. It is based on rates of return during 745 25-year periods over 1926-2012.

This table, based on the starting age and portfolio composition of a particular retiree, shows the estimated probability that this retiree will run out of money within life spans specified by the retiree. The retiree who finds the risk unacceptable can reduce the annual payment increase. This is useful information that places responsibility where it belongs – on the retiree. The alternative of convincing the retiree that the 4% rule would probably work is largely useless.