Using the 4% Rule Correctly may Also Mean you Need to Break it | ETF Trends

By Mike Kenney

Key Takeaways:

  • The 4% rule is a general retirement guideline suggesting that retirees can safely withdraw funds equal to 4 percent of their savings during the first year of retirement and then adjust for inflation each subsequent year for 30+ years.
  • The 4% rule is more of a benchmark or gauge than a steadfast rule—especially in today’s environment.
  • There is concern, however, that the 4% rule does not account for the goals of the retiree, asset location, or taxation. It has pitfalls which must be considered.

What is the 4% “rule”?

We’ve all heard of it. Put simply, the 4% rule is a general retirement guideline suggesting that retirees can safely withdraw funds equal to 4 percent of their savings during the first year of retirement and then adjust for inflation each subsequent year for 30+ years. But where did it come from? The 4% rule was first attributed to a 1994 study by William Bengen, a financial advisor in Southern California, who determined that a 4% withdrawal rate from a diversified investment portfolio, with annual withdrawal increases to keep pace with inflation, would last 33 years. Bengen said this would be the “worst case” scenario and suggested 5% was likely attainable.

Most iterations of the study assume a 50% stock, 50% intermediate bond portfolio, regularly re-balanced over the duration of retirement. The study looked at a fifty-year history of the sequence of returns of the S&P 500 dating from 1926 to 1976 along with the performance of bonds over that same time frame. Since Bengen’s initial study, there’ve been variations of the 4% rule using higher or lower stock holdings as well as different testing methods. In most of these studies, a portfolio using the 4% rule has a high chance of lasting for 30-plus years when measuring against the historical or even hypothetical performance of the markets.

But, rules were meant to be broken

Despite its performance in these studies, there is general agreement in the industry that the 4% rule is more of a benchmark or gauge than a steadfast rule. In today’s environment, it may be wise to consider the 4% withdrawal amount as a maximum withdrawal amount in the first year of retirement. Why? Stock prices have come down from all-time historical highs, interest rates are rising, and inflation is high. The likelihood is that price volatility for stocks and bonds remains high, so this makes certainty an important component of an individual’s retirement income generation strategy.  Guaranteed income products can help provide this certainty in volatile times.

The effect of the 4% in volatile markets

Let’s look at an example[1] assuming a 50% stock/50% bond portfolio with an initial balance of $500,000. In the first year of retirement, this hypothetical portfolio is exposed to a 25% decline in the S&P 500, an increase of 2% in interest rates that pushes down bond values by 20%, and let’s assume an inflation rate of 5%. Sound familiar?

It’s not all bad news

Markets generally recover and one bad year early in retirement will not necessarily derail an individual’s or a couple’s retirement. Plus, there are certain advantages to the 4% rule, like how it is:

  • Easy to understand and implement
  • Adjusted year-over-year for inflation
  • Designed to provide income for 30+ years
  • Considered a conservative approach (higher income levels may be obtainable)

Other ways the 4% rule may fall short

There is concern, however, that the 4% rule doesn’t account for the goals of the retiree, asset location, or taxation. It also doesn’t account for goals outside of retirement income such as leaving money to heirs or supporting charities. In addition, location of assets is generally not considered in the 4% rule. Think of the individual with the with the bulk of their assets in traditional IRAs. Taxation of these withdrawals will impact their actual spendable income. Some other factors to consider concerning the 4% rule include:

  • Not always followed year after year in retirement
  • Doesn’t account for needed emergency expenses
  • Provides no guarantees the portfolio won’t run out of money
  • Lacks flexibility

Another way to approach retirement income

First, consider all essential retirement expenses unlikely to ever go away in retirement.  These are often things like:

  • Housing and utilities
  • Transportation
  • Groceries and household goods
  • Health care and long-term care (premiums, co-pays, prescriptions)
  • Insurance premiums
  • Loans or other debt payments

Clients can then use an income planning worksheet to create their estimate, then review if following the 4% rule could produce enough annual income to sufficiently cover these essential retirement expenses.

Assuming it does, next clients can consider anticipated discretionary retirement expenses and how they may change throughout retirement as activity levels may change.  Discretionary expenses considered by most retirees may include:

  • Travel
  • Entertainment
  • Philanthropy or gifts to family

Then it’s time to perform the first 4% backflow test. If covering the essential expenses requires less than 4% of your client’s assets, move on to the next tier – the discretionary or lifestyle income goals. Once accounting for these projected costs, perform a second test of the 4% rule. If assets are adequate to meet these goals without reaching the 4% target limit, move on to those more aspirational goals. If assets will not support a 4% withdrawal rate at any point along the way, consider options such as working longer, reducing expenses, downsizing, or setting more realistic goals.

One size does not fit all

It’s important to note that the 4% rule is a general rule of thumb–NOT a plan. There are many facets to a retirement income strategy which need to be addressed.

Using the 4% rule as a starting point in building a retirement income distribution plan lacks full perspective of all the goals a retiree may have and that’s where a qualified financial professional can make the difference, guiding the retiree’s life savings through good markets and bad ones to help meet all their goals.

Everyone’s situation is different and adequate planning is key. There isn’t one specific strategy that works for each individual situation, but for most, having a protected source of income to cover their regular expenses is key. For some retirees, optimizing their Social Security filing strategy, considering tax-efficient withdrawal techniques and using the 4% rule for a portion of the portfolio may together provide desired levels of income for decades. However, especially for those near retirement  during periods of high inflation and market losses, the risks may be too high to fully trust the 4% rule on its own. For these retirees, greater levels of protected retirement income may be needed.

To learn more about guaranteed income solutions, view annuity options available from Nationwide.


Sources and Disclaimer

  • 1 This illustration is hypothetical and is not meant to project the results of any specific investment. If fees and expenses were deducted, the results would have been lower.
  • Nationwide and its representatives do not give legal or tax advice. An attorney or tax advisor should be consulted for answers to specific questions.

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