Why The 4% Retirement Rule Is No Longer Safe

By Randall Smith AAA

Ever since a California financial planner named William P. Bengen proposed it in 1994, retirees have relied on what’s known as the 4% rule – if they withdraw 4% of their nest eggs the first year of retirement and adjust that amount for inflation thereafter, their money would last at least 30 years.

But Bengen’s rule has lately come under attack. It was developed when interest yields on bond index mutual funds hovered around 6.6%, not the 2.4% of today, raising clear questions about how well bonds could support a 4% rule. As one academic paper, published earlier this year in the Journal of Financial Planning, put it: “The 4 Percent Rule Is Not Safe in a Low-Yield World.”

The paper by authors Michael Finke, Wafe Pfau and David M. Blanchett said that if current bond returns don’t spring back to their historical average until ten years from now, up to 32% of nest eggs would evaporate early. Mutual-fund managers T. Rowe Price and Vanguard Group as well as online brokerage Charles Schwab have all issued recent re-appraisals of the guideline.

Such estimates are crucial to helping people figure out how much savings they will need to make it through retirement without running out of money. They are tied to the fact that long-term returns since 1926 have been 10% annually for stocks and 5.3% for bonds, according to Morningstar, the investment research firm.

More Flexibility on Withdrawals

Of course investors can’t count on those returns to materialize every year given that market prices, especially for stocks, gyrate unpredictably. As a result, they need some withdrawal-rate estimates based on computer simulations of future market returns.

Even though some investment firms continue to advocate the 4% rule, several are advising retirees to be flexible and use a “dynamic” strategy by altering their withdrawals each year depending on the markets. A Morningstar paper by the three authors of the Financial Planning article found that a retiree with a 40% stock nest egg could withdraw only 2.8% initially and still have a 90% chance of success over a 30-year retirement. 

In an interview, author Blanchett attributed the difference to the impact of annual fund management fees, as well as lower expected future returns for stocks and bonds.

In contrast, T. Rowe Price, which offers a retirement income calculator, still believes that “4% gives you a high likelihood of success,” said Christine Fahlund, a senior financial planner at the Baltimore, Md.-based mutual fund firm. In a fall 2013 newsletter, the firm said clients with a mix of 60% stocks and 40% bonds – a relatively risky profile – could use an initial withdrawal rate of 4.3%.

They could use an even higher rate of 5.1% if they don’t take cost-of-living increases during years when their portfolios lost money, T. Rowe Price said.  Risk-adverse retirees with all-bond nest eggs should use a lower 2.8% initial withdrawal rate.

A ‘Dynamic Approach’

In October, Vanguard Group published an update which, like T. Rowe Price, also suggested “a more dynamic approach” under which withdrawals could be adjusted up or down depending on how markets perform.

Vanguard says investors with a nest egg evenly split between stocks and bonds who withdraw 3.8% initially with inflation increases would still have a 15% chance of running out of money within 30 years.

Vanguard estimates that an investor with 80% stocks and 20% bonds could withdraw 4% with the same 85% success rate. But Vanguard warned that a conservative investor with only 20% in stocks should limit initial withdrawals to 3.4% to have the same chance of success over 30 years.

Two Other Alternatives

In addition to the traditional Bengen model of starting with a set percentage and adjusting for inflation annually, Vanguard suggests two alternatives.

One is to withdraw a set percentage such as 4% annually - but instead of maintaining the starting dollar amount plus inflation each year, the investor keeps the percentage constant and allows the withdrawal dollar amount to fluctuate depending on the balance.

While this method ensures that the nest egg is never depleted, Vanguard warned that,  “this strategy is strongly linked to the performance of the capital markets.” Because spending levels are based solely on investment returns, “short-term planning can be problematic” as withdrawal amounts bounce around.

As a middle ground, Vanguard suggested that annual adjustments to the initial withdrawal amount be limited to a 2.5% reduction from the prior year when markets have declined and a 5% increase when markets have risen. Thus if the initial dollar withdrawal were $50,000, it could fall by $1,250 if markets decline in the first year or increase by $2,500 if markets go up. This method allows a heftier 4.9% withdrawal rate for a portfolio of half stocks and half bonds, with an 85% success rate over a 30-year horizon.  

Loading Up on High Yields

Colleen Jaconetti, a senior investment analyst at Vanguard who co-authored both studies, said that because current bond interest rates and stock dividend yields both fall short of 4%, some investors who “don’t want to spend from principal” are tempted to load up on securities with higher yields.

Instead, she recommends that investors “maintain a diversified portfolio” and “spend from appreciation,” meaning any price gains on stocks or bonds.   

At the online brokerage Charles Schwab, retirement income planning analyst Rob Williams says based on the firm’s current expectations for market returns, a 3% initial spending rate “may be more appropriate” for investors who need “a rigid rule of spending” and a high degree of confidence that their money will last.

Advice: Stay Flexible

However, Mr. Williams adds that even a 4% spending rate “may be too low” for investors who can remain flexible, are comfortable with a lower confidence level, and expect that future market returns will be closer to historical averages.

To balance the two perspectives, Schwab suggests investors stay flexible and update their plan regularly. Schwab suggests that a plan with a 90% success rate may be too conservative, and that a confidence rate of 75% may be more appropriate.

Two investment analysts at the Merrill Lynch Wealth Management unit of Bank of America, David Laster and Anil Suri, say that while the 4% rule may be overly simplistic, it isn’t too far off the mark.

They also recommend a post-retirement stock allocation of 30% to 40%, lower than some competitors, to reduce the risk of a catastrophic shortfall that could result from a steep market downturn early in retirement.  

The Bottom Line

Because women tend to live longer than men, the Merrill analysts say the average 65-year-old woman could initially only withdraw 3.9% annually, with cost-of-living increases, while a man the same age could start withdrawing at a higher 4.2% rate because he isn’t expected to live as long.

Using similar logic, they add, younger retirees in their 50s should start spending at about 3%, while those in their 70s can spend 5%.    

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