Used for decades, this approach to withdrawing from your retirement accounts may no longer be appropriate.
The 4% rule is a rule of thumb that has been around for years and is a common recommendation made by advisers in the industry. You may have heard your adviser reference this rule, one of the reasons being that the 4% rule is a fairly easy concept to grasp. The rule supports the idea that if your first-year withdrawal in retirement is 4% or less of your retirement portfolio, then your chance of outliving your portfolio is highly unlikely. So, the question is, in today’s economy does this rule still apply?
The 4% rule was born in 1994, when William Bengen published a research paper on it. In his research, he needed to start with a key assumption. This assumption was a specific asset allocation. In addition, he didn’t take into account other real world factors such as fees, inflation, and sequence of returns risk. All of these can lead to varying outcomes when following the rule (R. Berger, Forbes).
Asset Allocation: In his paper, Bengen assumed that the retiree would be allocating his portfolio in the following way: 50% in stock and 50% in bonds. He then created the portfolio and decided on a range of withdrawal rates he would test it on. Bengen’s findings are listed below (R. Berger, Forbes).
- If the withdrawal rate was 3%, then all portfolios tested lasted 50 years
- If the withdrawal rate was 4%, then most portfolios tested lasted 50 years
- If the withdrawal rate was 5%, then more than half of the portfolios tested were exhausted in less than 50 years
As you can see, an increase of just 1% in the withdrawal rate can have a big impact on the portfolio’s longevity. This impact can be affected even more by one’s allocation to equities. If the investor is more risk averse, then they will allocate less to equities, which will produce less growth in the portfolio. In turn, any increase in the withdrawal rate will have an even greater effect on the longevity of the portfolio.
Fees: Management fees and fees from advisers were not accounted for in Bengen’s analysis. The investor should be aware that high management fees coupled with the annual management fee charged by the adviser, could cause the 4% rule to fail. These fees need serious consideration at the end of the day since they effect how much money goes into your pocket. If fees are high enough, greater returns may be required from your portfolio in order to sustain your retirement, which in the end would mean taking on more risk. This is why your adviser routinely attempts to identify investments with lower expense ratios in addition to charging lower adviser fees such as 1.3% or less on assets under management.
Inflation: Inflation undoubtedly has a major impact on the 4% rule. In times when inflation is high, a retiree may have to withdraw more than expected to maintain their standard of living. But when inflation is low or deflation is present, the retiree wouldn’t have to take more and could put additional funds to the side. Hence, your adviser may suggest taking lower distributions during certain years while still maintaining the same lifestyle. As you may be able to see, this rule is helped out in times of low inflation, but in times with high inflation, this rule may be very difficult to follow without depleting portfolios.
The Sequence of Returns Risk: This deals with what the market is doing when a person starts withdrawing. If returns are down, it has an impact on the long term success of the model. The impact of these withdrawals cannot be measured immediately, but advisers can implement different strategies to minimize the long term effect of the withdrawals. However, the sequence of returns could increase the longevity and value of the portfolio if the investor began withdrawing in an up or bull market.
Now that you hopefully have a better understanding of the 4% rule and the factors that affect it, it is time to answer the question, “in today’s economy does this rule still apply?” The answer is yes and no. First, the 4% rule does not account for market conditions, which is a limitation of a rule created in the nineties. Another reason the 4% rule is considered to be outdated is that it is not dynamic enough for changes in spending patterns. A retiree may begin retirement by having high expenses before dropping off and then picking up in the later years (C. Bieber, Motley Fool). The 4% rule was not created to take this into consideration. On the contrary, the 4% rule can still be used effectively today. It is simple enough for anyone to use and allows one to have a starting base on the steady income they may or will receive in retirement.