Retirement savings: 3% is the new 4%

It's all relative. How much retirees can safely withdraw from their retirement account each year is a mostly a function of current stock values and interest rates, which tend to predict near-term returns. And when stock market valuations are well above and bond yields are well below their historical averages, as they are today, retirees should withdraw much less than 4% of their portfolio, assuming they want their nest egg to last over the course of their household's lifetime.

Or at least so say the authors of "Asset Valuations and Safe Portfolio Withdrawal Rates," a new paper that seeks to provide retirees and soon-to-be retirees with some new rules of thumb about withdrawal rates. The old rule of thumb, which traces its roots back to a 1994 paper published by financial planner William Bengen, suggests that you can safely withdraw 4% per year from your retirement accounts without worry of running out of money.

The new rule of thumb, however, says you need to consider both current bond yields, stock values as measured by what's called the cyclically adjusted price-to-earnings (CAPE) ratio, and your asset allocation before setting your withdrawal rate.

"Our simulations indicate that the safety of a given withdrawal strategy is significantly affected by the initial bond yield and CAPE value at retirement, and that the relative impact varies based on the portfolio equity allocation," wrote the authors of the paper, David Blanchett, CFA, CFP®, the head of retirement research at Morningstar Investment Management, Michael Finke, Ph.D., CFP®, a professor at Texas Tech University, and Wade Pfau, Ph.D., CFA®, a professor of retirement income at the American College.

In April, when the authors first conducted their work, when bond yields were 2% and the stock market had a CAPE of 22, the authors said a standard 40% stocks/60% bond portfolio with a 4% initial withdrawal rate had a less than 50% chance of lasting over the course of a 30-year retirement.

"That success rate is materially lower than past studies and has sobering implications on the likelihood of success for retirees today, as well as how much those near retirement may need to save to ensure a successful retirement," the authors wrote.

"The most important concept behind our research is that the 4% rule, and the majority of research that based on historical returns is unrealistic in today's environment given market valuations," says Blanchett. "Therefore, while 4% was, realistically, very safe historically, it is not nearly as safe for retirees today… 4% can still work, there's just not the same margin of safety that has been their historically."

Of note, the CAPE ratio, which is also called the Shiller P/E (named after its creator Robert Shiller, Yale University professor and Nobel prize winner), is a popular price-to-earning metric. The earnings portion of the CAPE equation is the inflation-adjusted average of 10-year trailing earnings. The average CAPE ratio from 1881 to 2012 has been 16.4, although it has been slightly higher since 1960, averaging 19.5. The authors also noted there has been a relatively strong relationship between CAPE ratios and future stock returns. In November, the CAPE was at 25.2 in November, suggesting that stocks might be overvalued and headed for a fall. The yield on the 10-year U.S. Treasury is presently 2.79%.

Also of note, the studied 132 different years and found that there are only seven periods where the CAPE was above 20 and the yield on 10-year bonds was below 3.3% (1898, 1900, 1901, 1936, 2010, 2011, and 2012).

So what withdrawal rate makes sense given today bond yields and stock market valuations?

For his part, Blanchett says 4% is a good starting point for a retiree that has a diversified portfolio, who is revisiting their withdrawal decision annually, and is willing to take the potential for lower income at some point in the future.

But an initial withdrawal rate of 3% might be an even safer starting point. "Since there are so many variables - age and remaining lifespan, longevity, risk aversion, asset allocation, and the like, it's hard to say anything really general except that our finding is that '3% is the new 4%,'" says Pfau. "Low bond yields suggest low future bond returns, and as CAPE is now over 25, that suggests lower future stock returns. Put those together, and sustainable withdrawal rates on a forward-looking basis could end up being less than what worked in the historical record."

Of course, if interest rates rise, that would help justify increasing the withdrawal rate, but this might be offset in terms of spending by any capital losses experienced in bond funds, says Pfau. Likewise, if the stock market drops, he says the sustainable withdrawal rate looking forward from that point will be higher, but with the portfolio losses the person might not be able to spend any more.

Finke agrees that 3% is the new 4%, but also says best strategy for retirees and would-be retirees who want their money to last a lifetime – in addition to using a 3% initial withdrawal rate - is to work a little longer, claim a larger Social Security benefit, and be willing to adjust your spending if your investments hit a rough patch. "If you're retired right now, just be realistic about what you should expect on a portfolio given today's stock and bond prices," Finke says.

And, if you're afraid of running out of money, Finke says you can also consider buying an advanced life deferred annuity. An advance life deferred annuity pays a monthly income later in life - say at age 80 or 85 - and can let you feel more comfortable about living well early in retirement.

Robert Powell is editor of Retirement Weekly. Email him atrpowell@allthingsretirement.com