Martin Hawes: Painting by numbers

I've been doing some numbers. This is nothing unusual, of course, I spend a lot of my life doing and reading numbers.

However, the numbers in question are important, because they tell people who are planning their retirement the kind of lifestyle they will be able to have. The numbers I have been doing are to prove or disprove the 4 per cent rule.

I have written about the rule of 4 per cent previously.

This is a rule of thumb that says that when you to start to use your investments for income in retirement, you can draw and spend 4 per cent of the capital in the first year of retirement and continue to draw that amount in real (inflation adjusted) terms for the following thirty years.

That means that if inflation is 2 per cent and you have $500,000 invested, you are able to take $20,000 in the first year, $20,400 in the second year, $20,808 in the third year and so on. Because you are drawing on both investment returns and the capital itself, your capital will gradually erode and according to the rule, it will be all gone in thirty years.

This rule of 4 per cent is critical because it gives an indication of how much you can spend and not have the money run out before you do. It is useful for those about to retire, but just as useful for younger people who are setting a goal for how much savings they will need.

However, the rule of 4 per cent has always been controversial. Some believe that 4 per cent is too much to take from an investment portfolio, while others believe it is too little. 

The numbers I have been doing were to check just that – is the 4 per cent rule a good planning guide or, is it too optimistic? 

The calculations are not difficult, but the assumptions are. In particular, you need to think about what returns will be over the next thirty years.

The rule of 4 per cent assumes an investor will use a balanced fund in retirement (50 per cent in shares and property, 50 per cent in bonds and cash). A reasonable assumption is that such a portfolio will give gross returns of 7 per cent. 

From this 7 per cent return, we have to deduct fees (1.5 per cent) and tax (for which I use a flat rate of 20 per cent). I further assumed inflation would be 2 per cent p.a. (the mid-point of the Reserve Bank's target).

The bottom line is that 4 per cent is a reasonable amount to draw from a retirement portfolio. The calculations show the retiree's capital would last 39 years. This is better than the thirty years that most people talk about and gives some confidence to those of us who use the 4 per cent rule as a planning estimate.

However, the 4 per cent rule comes with no guarantees. Returns may be lower than those set out above and in any event, there is always a chance there is a major fall in markets at the beginning of retirement. The rule of 4 per cent is a good guideline for planning, but not everything runs to plan.

Martin Hawes is a director of Lifetime Retirement Income.

Martin is an Authorised Financial Adviser and a Disclosure Statements is available from Martin Hawes on request and free of charge at martinhawes.com.

This article was originally published on stuff.co.nz on 9 April 2017. Read the original article here.

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