The mass media and retirement 101 seminars continue to deliver a message to retirees that spending 4% of one’s investment assets per year is the “safe” withdrawal rate and that withdrawing more than 4% can be problematic, potentially leaving the retiree without any investment assets in the later years of life. This strategy has become known as the “4% Rule”.
Since the 4% Rule has become a popular strategy for retirees, it's important to examine exactly what it means, where it came from, and if it is a viable strategy.
What is the 4% Rule?
The idea of the rule is that a person in retirement can spend 4% of their investment assets each year and sustain 30-years of withdrawals from assets. In any given year, 4% of the portfolio balance is withdrawn and used for spending needs. This spending number is said to be low enough to be able to endure the ups and downs of the market and keep up with inflation during retirement.
Where did the 4% Rule come from?
The rule comes from studies that looked at the real investment and inflation scenarios a retiree would have faced for 30-years over the course of US history. They looked back at how a 60% stock and 40% bond portfolio (rebalanced each year) would have performed during real market returns and adjusted for real inflation rates for 30-years. This scenario was run for each individual year from 1871 to 1985 to see what the lowest “safe” spend down rate was for each year.
The study found that some of the worst years to have retired were 1907 due to World War I and high inflation after the war, during the Great Depression in 1937, and then much of the 1970s due to stagflation.
The following chart shows that the absolute worst year to have retired was 1966 when the “safe” withdrawal rate was about 4%. This is where the 4% Rule was determined. A retiree in 1966 would have faced some of the worst investment returns the US has seen at the very beginning of their retirement. And to add to the problem, inflation rates were some of the highest the US ever experienced.
Is the 4% Rule a realistic expectation?
The study found safe withdrawal rates varied between 4% and 10% with the median rate closer to 6.5%. Spending only 4% of one’s investment assets each year was the “safe” withdrawal rate during the worst economic conditions a retiree could have ever faced since 1871. However, looking at the worst possible scenario and planning for this may not be realistic for everyone.
In the same study, assuming a 4% withdrawal rate, in most years the retiree would have had even more money than they started with after 30-years as illustrated in the following chart. In some scenarios, the retiree would have had significantly more money. The chart represents starting with a $100,000 portfolio at retirement. The green line represents the ending value after 30 years of withdrawals. For example, a 1985 retiree with $100,000 would have had approximately $250,000 after 30 years.
What is a realistic spending rate?
The truth is there is no set rule for a safe withdrawal rate during retirement. There cannot be a blanket rule for something that varies depending on when someone retires, market conditions during retirement, spending habits of the retiree, amount of wealth at retirement, other income sources, and length of retirement.
The study looked at an investment portfolio that remained at a 60% stock and 40% bond mix, regardless of market conditions. There was no room for changes to this allocation due to the high volatility in stocks or high inflation that affect bond prices. This is also not a realistic expectation in an actively managed portfolio that takes market conditions into account when making investment decisions.
What does this mean for retirees?
Knowing there is not a set rule for a safe withdrawal rate during retirement means retirees need to be dynamic in their strategies. Sticking to a "set it and forget it" plan is not a good retirement plan. The only constant in life is change itself.
Having a dynamic strategy that allows for changes in investment strategy, spending levels, and longevity expectations is the real expectation retirees should have. Undertaking all of this alone is also not realistic. With all of these variables and the importance of getting it right, having a professional who can help you navigate throughout retirement should be a priority during this stage in your life.
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