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The Wisdom of the Four Percent Rule is Fading


By , with Annuity FYI

Most retirees like things to be simple, and financial advisers have accommodated them. So for almost three decades, they have passed along a basic rule of thumb that suggested that retirees withdrew 4% of their investment portfolio annually, and adjust the amount for inflation.

But times are changing. A growing consensus of financial planning pros say this strategy no longer works. Instead, they say it makes much more sense to withdraw only about 3% a year if, like most people, you stick with traditional stock and bond investments.

The biggest reason behind the change is the belief that the stock market in coming years won’t fare as well as it has in recent years — an unusually benign period in which super-low interest rates funneled more money into the market. After all, there wasn’t any other good place to put it. Rates will start rising in 2022 as the Federal Reserve works to quell an outburst of inflation, and they could easily stay higher for the foreseeable future. 

The Basis of the 4% Rule

The 4% rule was meant to yield a consistent stream of annual income and give seniors a high degree of comfort that their funds would last over a 30-year retirement. It says retirees can withdraw 4% of the total value of their investment portfolio in the first year of retirement. Thereafter, the dollar amount increases annually, in step with inflation. By and large, this strategy worked.

The difference between a 4% rule and a 3% rule may sound somewhat minor, but it can have a big impact on retirees’ standard of living. For example, in using the 4% rule, an investor would be able to withdraw $40,000 from a $1 million portfolio in the first year of retirement. Using the 3% rule instead means that the first year withdrawal is only $33,000. The difference would become even more pronounced as the years roll by.

When the 4% rule was created in October1994 by former financial adviser William Bengen, average annual stock market returns were 8.6% and bond returns 2.6%. As mentioned, stock market returns have been higher in recent years – materially higher, in fact – but performance almost always returns to the historical mean at some point. It may not even do that because the stock market is pricier than the historical average. Future bond returns are harder to predict. They have been lower than 2.6% but could become that high as the Federal Reserve boosts rates. 

Goldman Sachs, for one, has forecast mid-single-digit annual returns, including dividends, for the next few years at least. If so, 4% annual withdrawal rates would exhaust retirement savings far too quickly.

Retirement Nest Eggs are a big Deal

Making the most of your retirement nest egg is no small matter for millions of Americans. More than 46 million of them are 65 or older, representing nearly 15 percent of the U.S. population, according to Aging Statistics. And the Social Security Administration says that roughly 11,000 Americans, on average, will turn 65 every day for the next 15 years. Even more important than how much they can spend each year is the necessity that they not exhaust their savings while they are alive. 

In fairness, it should be noted that the 4% rule was always far from perfect. Some financial advisers used it as a guidepost for clients solely to get them started in their first year of taking withdrawals. In addition, it has always been true that most retirees don’t withdraw and spend their money in a linear fashion. Some people may want to spend more early in retirement and others may be willing to take special steps to leave more money to their children. Also true is that some people have never followed the core principal upon which the 4% rule rests – that it’s foolish to sell retirement assets in a bear market.

But at least the rule served as a guidepost. Some advice is obviously better than no advice. Downgrading the 4% rule is especially important because retirees are living longer. According to the Society of Actuaries, a 65-year-old man today is expected live another 21 to 22 years on average and a 65-year-old woman another 23 to 24 years. And many 65-year-olds will live much longer than this – and in an era in which relatively few people have pensions anymore.

The link between life expectancy and retirement security cannot be overestimated. Say, for example, that somebody has $50,000 in annual expenses. For someone who lives 18 years, that totals $900,000. If he or she instead lives 21 years, this figure rises to more than $1 million. These figures are even higher, of course, when you factor in inflation.

Can something be said for planning a 20-year Retirement?

One seemingly simple solution might be to plan on a portfolio supporting you for only 20 years. That might, in fact, even allow you to increase, not decrease, your annual withdrawal rate, say to 5% or 6%. The obvious problem with this approach is that unless you’re positive you will die within the next 20 years – say, for example, you have a life-shortening disease – it is simply too risky.

A more realistic solution might be to invest in one or more annuities to pay a hefty portion of your monthly bills in retirement without worrying about how long your money will last. Some annuities offer lifetime income payouts paying as much as 5% annually, starting at age 65, and deferred income annuities usually pay more. Retirees might also consider putting much of the rest of their retirement funds in non-market correlated investments such as commodities, managed futures contracts, federal government-sanctioned Business Development Corporations and Real Estate Investment Trusts, all purchased through qualified financial advisers.

Sequence of Return risk

At absolute minimum, pre-retirees and retirees should be mindful of so-called sequence of return risk – the notion that the ultimate performance of your investments depends heavily on the trajectory of the markets in the early years of retirement. If the stock market nosedives in the initial years, while you’re also regularly withdrawing retirement funds, you might eventually exhaust your nest egg prematurely because you no longer have the principal required to recoup losses. The only way to avoid this is withdraw materially less money that once planned in the first five years of retirement, albeit this is much easier said than done.

There are ways that retirees can strike a compromise of sorts – i.e., dial down the 4% rule to, say, 3.5%, not 3%. One way to help do this is to delay claiming Social Security until age 70 to maximize guaranteed monthly payouts. This may ease leaning on your investments as much. 

Another important consideration is whether or not you have a good feel for when it’s best to tweak the amount of your withdrawals. The aforementioned rules – whether the 3% rule or the 4% rule — assume that retirees don’t adjust their spending to changing market conditions. In fact, however, many seniors fluctuate their spending and withdrawal rates throughout retirement. So if, for instance, you tend to spend less when the stock market is down – if for no other reason than that it makes you nervous – then you’re under less pressure to trim the 4% rule. 

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