A Safer Approach To Retirement Income Planning
The relationship between stock market valuations and sustainable spending rates has great implications for retirement planning when we consider how the pre-retirement savings phase and the post-retirement withdrawal phase can be linked through the stock market valuation level at retirement.
When considered as a whole, the historical data show that, though the relationship is not perfect, the lowest sustainable spending rates (which give us our conception of the safe withdrawal rate) tend to occur after prolonged bull markets. Prolonged bear markets during the accumulation phase tend to allow for much larger spending rates in retirement.
This tendency motivates a fundamental rethink of retirement planning, as worrying about the “safe” withdrawal rate combined with a “wealth accumulation target” is distracting and potentially harmful for those engaged in the retirement planning process.
Rather, it is better to think in terms of a “safe savings rate” that has demonstrated success in financing desired retirement expenditures for overlapping historical periods including both the accumulation and distribution phases. Put another way, someone saving at her “safe savings rate” can expect to finance intended expenditures with as much confidence as we give the 4% rule (i.e., it worked in historical data), regardless of her actual wealth accumulation and withdrawal rate. This approach has actually led to lower withdrawal rates in recent years that are more reasonable in a low-yield, high-valuation world.
Thus far, we have focused on sustainable spending rates for retirement. It is worth taking a moment to understand how this links to pre-retirement savings. I define the traditional approach to retirement planning as a four-step process:
Step 1: Estimate the withdrawals needed from financial assets to pay for planned retirement expenses after accounting for Social Security, any defined-pension benefits, and other income sources. Define these planned retirement expenses as a replacement rate (RR) from pre-retirement salary.
Step 2: Decide on a withdrawal rate (WR) you feel comfortable using based on what has been shown to be sufficiently capable in the historical data.
Step 3: Determine the wealth accumulation (W) you wish to achieve by retirement, defined as W = RR / WR.
Step 4: Determine the savings rate you need during your working years to achieve this wealth accumulation goal.
In my research on safe savings rates, I suggest the following retirement planning process as a replacement:
Step 1: Same as step 1 above.
Step 2: Decide on a savings rate you feel comfortable using based on what can sufficiently finance your desired retirement expenditures based on historical data.
If you save responsibly throughout your career, you will likely be able to finance your expenditures regardless of what withdrawal rate this implies. Of course, a caveat must be included that the safe savings rate is merely what has been shown to work in rolling periods from the historical data.
The same caveat applies to the safe withdrawal rate. Either rate may need to be revised upward or downward in the future. It must also be clear that the findings about safe savings rates in this study are not one-size-fits-all. The study merely illustrates the principles at work by focusing on the case of a particular stylized individual.
Real people will vary in their income and savings patterns, consumption smoothing needs, desired retirement expenditures, and asset allocation choices.