The so-called 4% rule has been the standard advice given from financial professionals for several decades now. This method recommends clients withdraw 4% of their assets each year in order to provide income while maintaining enough principal to last throughout retirement. While the concept of the rule was appropriate for the time it was created, it isn’t as applicable in today’s environment.
When the 4% rule was created, interest rates were much higher, capital markets were less volatile and Americans weren’t living as long. In our current economic situation, it’s fairly safe to assume that the 4% rule is obsolete. In an effort to prove this point, the author of a recent CNBC news article conducted the necessary research. The following is what he found.
The analysis done was centered around the variables that most affect people’s income in retirement: life expectancy, health care needs, equity market volatility, and the rate of inflation. Based on today’s numbers, here’s what was found:
Life expectancy: The average life expectancy for a 65-year-old is an additional 19 years for men and 22 years for women. There is a 50% probability that one member of a male-female couple age 65 will live until around the age of 92, a 25% chance of person might reach 97 and a 5% chance of them living to 100. Additionally, a third of all 65-year-olds today will live past 90, with 1 in 7 living beyond 95. Given these numbers, a reasonable retirement planning goal might be 30 to 35 years. That’s a long retirement to fund.
Health care needs: About 50% of 65-year-old adults can expect to experience a physical or cognitive impairment over the remainder of their life. Many insurers are no longer selling traditional morbidity-based, long-term care policies, which is evidence that older-age health needs are viewed as a largely uninsurable risk.
Inflation: A modest 2% annual inflation rate would require a doubling of an individual’s retirement income over 35 years to maintain purchasing power. In comparison, a 3% inflation rate would lower that time to 23.5 years, requiring income to almost triple during a 35-year retirement. Just a 1% rate would require a 41% increase in retirement income over 35 years.
Equity Market Volatility: A significant equity market correction, a decline of 20%, within the first 10 years of retirement increases the risk of prematurely running out of income. The analysis found that individuals who are using a conservative 60/40 equity-to-fixed-income investment mix, coupled with a 4% withdrawal rate indexed for inflation, in the event of an equity market correction during the first decade in retirement, will be at a significant risk of running out of money.
This means that many Americans entering retirement are facing a considerable financial risk from the “trifecta of longevity, equity market volatility and uncertainty of older age health costs and long-term care.” And it appears that the 4% rule is no longer a safe or effective way for retirees to plan for retirement income.
With the virtual disappearance of pension plans, millions of Americans are left without a source of protected lifetime income, however there are financial products that can fill this gap. Target date funds, mutual funds and exchange traded funds are often used to generate retirement income, but the only financial products that specifically provide protected lifetime income are annuities.
This study has demonstrated that the 4% rule is no longer an effective way for retirees to plan for retirement income. Given today’s economic environment and the variables that affect people’s retirement income, a new, more appropriate strategy should include protected lifetime income from annuities.
Written by Rachel Summit