Planning for retirement can be stressful. In addition to preparing for a different lifestyle, people always worry about money. Have I saved enough? How should I invest it? And then there is the whopper of a question: How much can I spend each year in retirement and not have to worry about running out of money before I die?
Financial planner William Bengen proposed an answer to that question when he developed the 4 Percent Rule in 1994. He assumed the average person would have a 30-year retirement. He devised a theoretical, diversified investment portfolio that contained 60% equities and 40% fixed income. Using stock market returns from 1926 until 1993, he reviewed every rolling 30-year period, and concluded that, in a worse-case scenario, a 4.15% withdrawal rate would have sustained a portfolio for at least 30 years.
Bengen’s original plan was to withdraw 4% during the first year of retirement, and then increase the withdrawal amount each year by an inflation factor, such as 2% or 3%. If a recent retiree had investments that totaled $1,000,000, she could assume an initial withdrawal of $40,000. This is in addition to other sources of income such as Social Security, pensions and part-time employment. The following year the withdrawal would increase to $40,800, if a 2% inflation factor is used.
The 4 Percent Rule does not apply in every situation:
- Large sums of money in bank and credit union accounts cannot be counted as a part of the investment portfolio because often that money is actually losing value each year due to inflation.
- Too much of the portfolio in one sector (such as technology) would not be considered diversified.
- High fees (including commissions) in the investments would negate the 4 Percent Rule because the high fees will negatively impact the portfolio’s growth.
- Retiring at a young age (in 50s or early 60s) may not work because the retirement period may exceed 30 years.
Debating the rule
Since 1994 many financial experts have debated the 4 Percent Rule. In 2004 financial planner Jonathan Guyton added decision rules and guardrails to the concept of withdrawal rates. Guyton was focused on whether a retiree could withdraw more than 4% if flexibility was applied based upon the recent performance of the retiree’s investment portfolio.
In my experience with clients, having them agree to reduce their withdrawals if investment performance has been weak is essential. Postponing the replacement of a car or delaying a vacation for a year or two is typically an easy solution, which can then give the portfolio a chance to recover from a downturn. Likewise, the withdrawal percentage can increase after strong performance within the portfolio. I do not assume that the withdrawal amount needs to increase each year with inflation. Holding the withdrawal amount constant for a few years provides an added safeguard.
In 2013 three researchers (David Blanchette of Morningstar and Wade Pfau and Michael Finke of the American College) concluded the “safe” withdrawal rate should be 2.8% rather than 4%. They based their research on projecting future stock returns and bond yields as low, which is a very different methodology than Bengen’s review of almost 70 years of historical data. Their research is the basis for some financial advisers now recommending an annual withdrawal rate of 3% rather than 4%.
Most financial experts agree that the riskiest time for a retirement portfolio is the first few years after retirement. If a retirement nest egg plummets in the first few years of retirement, it may never recover, and may be depleted in far less than 30 years. Based upon this premise, Michael Kitces, director of wealth management at Pinnacle Advisory Group, proposed a Glidepath strategy that recommends a conservative portfolio at retirement, with the equity percentage increasing gradually throughout retirement.
Is it still valid?
As long as everyone understands it is only a rule of thumb, I think it is still useful. However, I believe flexibility with withdrawal rates (tightening the belt) is essential during market downturns.
Most retirees do not spend consistently each year, so their withdrawal percentage may be erratic. In addition to expenses fluctuating from year to year, the performance of an investment portfolio can fluctuate significantly. This is why the flexibility is so important.
Retirement projections using sophisticated software that can incorporate many variables address some of the risks. Revising retirement projections each year is valuable because recent market performance, upcoming expenses (such as a replacement car), assuming a conservative average future return – combined with a higher-than-normal inflation factor – can all be projected to age 95 or beyond.
In summary, I believe the 4 Percent Rule is a useful tool if flexibility is built into the withdrawal rate. Retirement should be a time for trying new things and spending time with friends and family. However, your finances need your attention too, so don’t neglect your investment portfolio, your spending or your withdrawal rate. If managed wisely, your investments will serve you well throughout retirement.