Retirement planning is a complex puzzle, and one big piece is determining how to distribute your savings to ensure a comfortable retirement. For decades, the 4% rule has been the rule of thumb for retirement withdrawals. This rule suggests that retirees can withdraw 4% of their retirement savings every year for the duration of their retirement. However, as economic landscapes and life expectancies evolve, the original 4% rule is increasingly being considered outdated and in need of a revamp.
The 4% rule was first introduced in 1994 by financial planner William Bengen and quickly gained popularity. Bengen used historical market returns to determine a withdrawal rate that would sustain a 50% stocks and 50% bonds retirement portfolio for 30 years. His research suggested that a 4% initial withdrawal rate, adjusted annually for inflation, would provide a high probability of sustaining a 30-year retirement period.
New research finds this may not be the case. A recent paper, “The Safe Withdrawal Rate: Evidence from a Broad Sample of Developed Markets” (by A. Anarkulova, S. Cederburg, M. O’Doherty and R. Sias), found that a 65-year-old couple willing to bear a 5% chance of retirement failure can withdraw only 2.26% of retirement savings per year. This is significantly lower than the 4% rule.
Challenges to the 4% Rule
Many factors contribute to the suggested rule change, including the following:
Low-Interest Rates: One of the challenges to the 4% rule today is the low-interest-rate environment compared with the ‘80s and ‘90s. While there has been excitement about interest rates now shooting up over 5%, historical bond yields were significantly higher, reaching double digits in the ‘80s and high single digits in the ‘90s. Therefore, today’s retirees must choose between safety or income, which can undermine the 4% rule.
Longevity Risk: With advancements in healthcare and increased awareness of healthy living, people are living longer. Many people are also considering retirement at earlier ages, which means retirement savings may need to last 40 or more years, rather than the 30-year period for which the original 4% rule was designed. Outliving savings becomes a real concern for retirees.
Sequence of Returns Risk: Beyond the rate of return for retirement savings, a bigger risk is the sequence of investment returns. If a retiree experiences poor investment returns during the first few years of retirement, their savings can erode significantly, making it difficult to recover even if markets perform well in later years. The 4% rule assumes a constant and predictable rate of return, which is not realistic.
Inflation: The 4% rule's built-in inflation adjustment may not accurately reflect the actual rising costs retirees face. Healthcare and long-term care expenses, in particular, can rise substantially faster than general inflation, potentially depleting a retiree's savings and purchasing power over time.
Taxes and Investment Fees: The cost of taxes and investment fees is not included in the 4% rule. It assumes the retiree uses the money distributed to pay any taxes and fees. This reduces the net amount available for spending. Tax planning is an important part of retirement planning, and Uncle Sam will always want his share.
Strategies To Consider
Retirees and retirement distribution experts have explored alternative strategies to address the shortcomings of the original 4% rule. Some of these alternatives include the following:
Bucket or Ladder Strategy: This strategy separates a retirement portfolio into different segments or buckets with different time horizons and investment objectives. The immediate expense bucket is in cash or safe assets, while longer-term horizon buckets are invested for income or growth.
Dynamic Withdrawal Strategies: As the name suggests, withdrawal rates and/or sources of money adjust based on market performance and personal circumstances. This provides more flexibility around retirement spending; however, retirees should prepare for potential income changes.
Adding Guaranteed Income: Pensions, annuities and other guaranteed income products provide a stable income floor, providing peace of mind even in volatile markets.
Increasing Equity Exposure: For those with a longer retirement horizon, maintaining a higher allocation to equities can provide better growth potential, although this comes with increased risk.
The original 4% rule, which served as a guideline for retirement distribution, may now be insufficient for the retirees of today and tomorrow. It's essential to recognize the limitations of this rule and consider more customized strategies to ensure financial security and increase savings throughout retirement. The key to a successful retirement lies in a combination of careful planning, diversified strategies and the option to adapt to changing circumstances. Ultimately, the appropriate retirement withdrawal rate for you will depend on your individual circumstances. Work with a CERTIFIED FINANCIAL PLANNER™ professional to develop a personalized plan that meets your unique retirement goals and risk capacity. Find your CFP® professional today.
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