In the financial advisory business, one of the most pressing and controversial topics is how much money people need to save during their working years in order to provide for long-term retirement income. The research on this topic has evolved quite a lot in recent years, and a recent issue of Money magazine features a series of articles representing the current view on this critical topic. These articles, based around interviews with a number of the current thought leaders on this topic, deserve to be widely read and discussed.
The series of articles in Money kicks off with perspectives by Wade Pfau. Pfau’s introductory piece suggests a difficult future for American workers. A traditional rule-of-thumb in retirement planning is called the 4% rule. This rule states that a retiree can plan to draw annual income equal to 4% of the value of her portfolio in the first year of retirement and increase this amount each year to keep up with inflation. Someone who retires with a $1 Million portfolio could draw $40,000 in income in the first year of retirement and then increase that by 2.5%-3% per year, and have a high level of confidence that the portfolio will last thirty years. It is assumed that the portfolio is invested in 60%-70% stocks and 30%-40% bonds. The 4% rule was originally derived based on the long-term historical returns and risks for stocks and bonds. The problem that Pfau has noted, however, is that both stocks and bonds are fairly expensive today relative to their values over the period of time used to calculate the 4% rule. For bonds, this means that yields are well below their historical averages and historical yields are a good predictor of the future return from bonds. The expected return from stocks is partly determined by the average price-to-earnings (P/E) ratio, and the P/E for stocks is currently well-above the long-term historical average. High P/E tends to predict lower future returns for stocks, and vice versa. For a detailed discussion of these relationships, see this paper. In light of current prices of stocks and bonds, Pfau concludes that the 4% rule is far too optimistic and proposes that investors plan for something closer to a 3% draw rate from their portfolios in retirement. I also explored this topic in an article last year.