Is the 4 Percent Rule Still Relevant?

You may have heard the rule of thumb describing that it’s “safe” to withdraw a certain percentage of your investments each year in retirement.

While “rules of thumb” can be guides in decision-making, they should NOT be driving major financial decisions. When you apply a rule of thumb to your personal retirement portfolio, there are a myriad of factors that need to be taken into consideration, such as income taxes, inflation, life expectancy, stock market performance, other income sources, just to name a few. That is why we believe ongoing customized financial planning with a trusted advisor is the only way to truly achieve your personal financial goals. It’s that tailored plan for you, closely managed and adjusted as your life changes, that will be better to follow than a generic rule of thumb.

What is the 4 Percent Rule?

 In 1994, financial advisor Bill Bengen gained notoriety as the first to articulate the “4% rule,” which was a 4% safe annual withdrawal rate from retirement savings. The theme was to determine how much could be safely withdrawn each year from your retirement portfolio for 30 years with an adjustment for inflation. He used every 30-year period from 1926 to1994 in the analysis.

To put that in numbers, for a $1 million retirement portfolio, that would be an annual withdrawal of $40,000 during the first year of retirement, with annual increases for inflation. Here’s what that looks like over a 30-year period:

So, Has This “Rule” Worked and How Would it be Applied Today?

 At the time, Bengen was only using two asset classes, large company stocks and U.S. Treasury Notes. We were in a very different time in 1994, as it was a higher inflationary environment than we’ve had in the ensuing years since that time (early 2022 notwithstanding). Also, the interest rate environment has changed significantly, with interest rates dropping to near zero today, and only just beginning to rise, while still not near historic levels. At the time, Bengen’s safe rate was 4.15% of withdrawals per year, and that was for a portfolio with 50% in stocks and 50% in bonds.

These differences in interest rate trends, inflation over several decades, asset classes used, and the balance of stocks and bonds are all very specific to that 4% rule. Your individual portfolio may reflect very different trends, current economic realities, and balances of assets.

Potential Concerns With This 4% Rule:

• It uses historical market returns, which could result in a withdrawal rate that is too high. Many experts predict returns to be lower over the next decade than they have been in previous decades.
• Assumes a specific portfolio allocation of 50% stocks and 50% bonds, while your portfolio allocation may differ and you may change it over time.
• The spending level is rigid at 4% to start, with an inflation increase each year. Your expenses may change each year, and most people don’t withdraw from their accounts this way.
• Life expectancy is assumed to be 30 years. Your retirement time horizon may be more or less, depending on when you retire, and your family and health history.
• Incomes taxes are not accounted for. Income tax rates are not flat, so depending on how much you withdraw and whether it’s considered taxable income will cause the results to be different.
• Investment fees are not accounted for. Your portfolio may have higher or lower fees than someone in a similar situation.
• This assumes a 90 percent probability of success. You may be comfortable with 80 percent or 85 percent probability of success.

Morningstar recently published “The State of Retirement Income: Safe Withdrawal Rates,” using forward-looking estimates for investment performance and inflation. They estimate the rule of thumb should be lowered to 3.3 percent per year, assuming a balanced portfolio, fixed real withdrawals over 30 years, and a 90% probability of success. They add that these assumptions are very conservative, so that it should not apply to everyone.

There has also been research that says that if you adjust your withdrawals based on portfolio performance, it could increase your probability of success, which means withdrawing less in down markets and more in good ones. Morningstar has shown that your withdrawals could be closer to 5 percent per year in some flexible withdrawal systems, so it really depends on your specific financial situation.

If you want to feel comfortable with your personal withdrawal rate for retirement, you should consider working with an experienced, trusted financial advisor who can build your retirement projection to meet your specific financial goals. Especially seeking out one who is a CERTIFIED FINANCIAL PLANNER^TM Professional, and who is bound to act as a fiduciary, only making recommendations in your best interest. This can help you feel confident and comfortable with your financial plan.

Factors to Consider:

• What age are you retiring? What would be an accurate life expectancy?
• Is your inflation assumption realistic? Have you stress-tested different inflation rates?
• Are you factoring in health care costs that have a much higher inflation rate?
• Are college education goals for children or grandchildren part of your financial plan? Is your inflation assumption for those costs realistic?
• At what age(s) will you begin drawing your Social Security benefits?
• Do you have any pensions or guaranteed income annuities?
• Do you have any rental property income or will you be working part-time in retirement?
• Where are your assets invested? In after-tax accounts, pre-tax IRA/401(k)s, or tax-free Roth IRAs?
• What income tax rates are you assuming? Which sources of income are taxable income?
• What rate of return are you projecting for your portfolio? Are you also stress-testing at different rates of portfolio returns?

It’s also possible that your withdrawal rate will vary over time. For example, if you retire at age 62 and delay your Social Security benefits until age 67 or age 70, you may draw a higher percentage from your portfolio in the short-term until your Social Security benefits begin.

It’s also likely that your spending will be higher in your 60s and 70s than it will be in your 80s and 90s. So, your retirement projection could factor in discretionary spending on travel or other activities during your early retirement years.

Another consideration could be covering your basic day-to-day, must-have living needs from guaranteed income sources, such as Social Security, Pensions, or guaranteed income annuities. Your discretionary spending needs can be covered by your managed investment portfolio. Keep in mind that each situation is unique, so an experienced financial advisor will help you determine your optimal strategy.

Does Timing of your Retirement Matter?

Yes, it can. A weak market environment right after you retire could significantly diminish your retirement portfolio, which could force you to reduce your withdrawal rate. On the other hand, it has been proven that having a strong positive market right after you retire provides you with “wind at your back” moving forward.

Will Stock Allocations Matter?

Yes, your portfolio allocation will matter. A mix of stocks, bonds, and cash is important. Your asset allocation, or how much you have in stocks vs. bonds, will likely have a significant impact on your portfolio’s ending balance. Research shows that the pain of losses exceeds the pleasure of gains, and this can be magnified in retirement. Partnering with an experienced advisor can guide you through your portfolio selection.

Charles Schwab’s Center for Financial Research provides the following initial withdrawal or spending rates. These spending rates assume that you will follow that spending rule throughout the rest of your retirement and not make future changes in your spending plan. In reality, they suggest you review your spending rate at least annually with your advisor:

As you can see, this 4 percent safe withdrawal rule of thumb may not work for your specific situation. Taking the time to factor in these items can help to provide you with peace of mind that your retirement goals will be met.

Contact Domani Wealth today to develop your personalized retirement plan. We can come by your side and help you feel prepared for retirement, and provide ongoing advice for your optimal strategy on drawing retirement income.  You can get in touch with us by calling 855-855-5455 or emailing [email protected].