The TV show “Friends” had just debuted, and the most popular song of the year was “The Sign” by Ace of Base when financial adviser William Bengen created the 4% rule, a guideline general on the amount to be safely withdrawn at retirement. But that was in 1994, and it’s fair to wonder if his formula still holds.
How the 4% rule works
Let’s say you start with a portfolio of $2.5 million. In your first year of retirement, you can withdraw 4% of your total balance or $100,000.
This sets your baseline. Each year thereafter, the withdrawal amount increases with the rate of inflation. If inflation is 2% in the second year, you withdraw $102,000.
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In theory, this formula means that “under the worst-case investment scenario, your savings should last another 30 years,” says Karen Birr, retirement advisory manager at Thrivent in Minneapolis. In practice, however, the formula may need adjustment as Bengen made several assumptions when designing the rule that do not always apply today.
First, he assumed that a retirement portfolio would be split approximately 50/50 between stocks and bonds, basing returns on historical market data from 1926 to 1976. “There are some issues with using the historical returns,” says Dan Keady, a Certified Financial Planner. and Chief Financial Planning Strategist at TIAA in Charlotte, North Carolina. For one, bond interest rates were higher then, while Keady says retirees today
might need a higher equity allocation – up to 75% – to generate enough income.
Investing more in stocks in a bear market when the bottom seems nowhere in sight can be hard for retirees to bear. Another option, then, is to reduce the base withdrawal rate from 4% to “a little over 3%, maybe 3.3%,” Keady says. . This means that you will either have to accept less income or have more savings for retirement. To generate the same income at 3%, your portfolio must be 33% larger.
Bengen also assumed that retirement savings should last 30 years. Over time, however, life expectancy has increased and today savings may need to last 35 or even 40 years. That too could involve a 4% rate cut, except some financial advisers say that risks too much austerity, especially if markets rebound. “We often see people being so careful with their spending that they end up with more money three to five years after retirement,” says Sri Reddy, senior vice president for retirement and income at Principal Financial Group at Des Moines, Iowa.
In fact, Bengen himself suggested raising the target rate to 4.5% or even 5% when he saw that many retirees were dying before they spent their savings.
“Having a surplus at the end of life is not a bad thing,” says Birr. “Just make sure it’s something you want.”
If you’re worried about outliving your savings, Keady suggests rolling a portion of your portfolio into an annuity for guaranteed income for life. An annuity combined with Social Security should provide enough income to cover basic needs, with the 4% rule applying to your investment portfolio for discretionary spending, such as vacations and hobbies. In a bad investment year, discretionary spending can be reduced without affecting the essentials.
Inflation. When Bengen created the 4% rule, inflation averaged 2% to 3%, down from 8.6% in May. For new retirees, withdrawing more initially to keep pace with inflation, especially when the market is down, can disrupt retirement planning. Let’s say we have two years of 7% inflation, says Keady.
Someone who started withdrawing $100,000 a year would withdraw $114,490 in the third year. This is hard to sustain because you will continue to increase those higher than expected withdrawal rates.
One solution is to review your portfolio’s performance and inflation each year, adjusting the withdrawal rate based on your target. If inflation drives the base withdrawal rate up to 6% per year, reduce it.
If a bull market drives your portfolio balance up, you may be able to withdraw less than 3% or 4% without changing your lifestyle. Once you reach age 72, the required minimum distributions may require you to withdraw more than you want. “The first-year RMD percentage starts at 3.65% and increases as you get older,” says Birr.
The annual adjustment of the withdrawal rate also satisfies another Bengen hypothesis: pension expenditure increases linearly when in fact it fluctuates.
Retirees tend to spend earlier. “As you age, spending typically slows, before eventually picking up health care costs at the end of life,” Reddy says. He prefers customers to spend more upfront and adjust their budget later if it looks like they might run out. Remember that the 4% rule is only an estimate because everyone’s situation is different, says Birr. “Life events are going to happen, and you have to be flexible.”