4% Rule: Made to Be Broken?

A common concern among investors is running out of money in retirement. Combating this concern, the “4% rule” is widely presented as a simple way to help your money last. Created in 1994 by financial planner William Bengen, the 4% rule says if you withdraw 4% of your nest egg each year, adjusted annually for inflation, there is a 90% chance your money will last at least 30 years. Yet despite its notoriety, the 4% rule is not without issue.

The Issues

  1. It doesn’t account for an “early in retirement” bear market. The rule assumes investors will experience several bear markets (-20% or more market decline) over their 30-year retirement. That makes sense since a bear market, on average, occurs every 3.5 years and lasts 15 months. But if one of these declines occurs in the first year of retirement, the math changes.

Assume you begin retirement with a $1,000,000 nest egg. Then, after you withdraw your first year’s disbursement ($40,000), the market falls -30% in the ensuing 12 months. At year-end, your portfolio stands at $672,000. When you withdraw your next disbursement of $41,200 ($40K adjusted for 3% inflation), you are now withdrawing 6.1% of the portfolio. A higher withdrawal rate leads to quicker depletion of the assets, all else being equal.

  1. It’s outdated. When the 4% rule was created, the Federal Funds rate was near 3.0%, what we thought then was a low interest rate. Additionally, the 30-year U.S. Treasury Bond was yielding over 8% by the end of 1994. Jump to 2016 and the Fed. Funds rate is 0.25%, while the 30-year U.S. Treasury Bond yields ~2%. Suffice to say, things have changed significantly.

The 4% rule assumes a portfolio consisting of 50% equities and 50% bonds. The historically low interest rates on bonds today make it harder to sustain a 4% withdrawal rate. To increase rate-of-return, then, investors must seek out securities with higher rate-of-return potential (perhaps by increasing the portfolio allocation to common stocks or junk bonds). But as we know, increasing rate-of-return potential comes with inherently greater risk.

  1. It relies on normalized inflation. The 4% rule is based on a normal inflation rate (2-4% annually). That’s fine today, even conservative, since inflation is low, below 2%. The problems start if (when) annual inflation rates move higher. As recently as the early 1980’s, inflation soared above 10%. While infrequent, inflation above 4%, or even double-digit inflation, is not unprecedented. If you commit to a 4% withdrawal rate, you would see your purchasing power erode quickly under high inflation.                                     

Bending the Rule

The 4% rule isn’t ideal, but it needn’t be broken completely. Investors can easily adjust the rule to achieve peace of mind regarding withdrawal strategy. For example, as your portfolio increases/decreases in value, your withdrawal amount (in dollars) should also (i.e., maintain a constant 4%, not a constant $40K + inflation). If your $1,000,000 portfolio increases in value by 10% in the first year of retirement, you can withdraw up to $44,000 (4% of $1.1M). Conversely, if the portfolio declines in value by -10% in the first year, you can withdraw only $36,000. Is it harder to plan expenditures this way? Yes. But it ensures your withdrawals do not erode the value of your assets too quickly. The bright side is, you have the option to withdraw less than 4% in good performing years, which further protects you from running out of money and can be used to supplement lower cash flow in negative years.

Simply put, no one should blindly follow any single withdrawal strategy. Retirements often last 25+ years, meaning investors will experience many different economic environments (expansions, recessions, inflation changes, interest rate fluctuation, etc.). Therefore, the withdrawal strategy should be flexible. All investors are different. Many don’t need 4% annually to obtain a comfortable standard of living, while others may need more than 4%. Having one blanket strategy that doesn’t accommodate different market environments, is ill-advised. Rules are often linear…life is not. Monitoring personal expenses, working with a trusted, knowledgeable investment adviser, and adjusting to market conditions are the surest ways to make your money last and keep your golden years golden.