Does the 4% Rule still work?

Planning for retirement requires us to make assumptions about our own lives and the world around us. The planning process typically starts with an analysis of our expected sources of retirement income: an investment portfolio, social security, a pension, real estate owned, annuities and a possible inheritance. The next steps include the factoring in of our age and expected lifespan, our anticipated spending needs and an annual adjustment for inflation. The result of this work is the calculation of a safe or sustainable withdrawal rate which over the long term should enable us to outlive our savings. Many retirees have long relied on the popular 4% Rule for calculating their own sustainable withdrawal rate. Here is how it works.

In the first year of retirement, you withdraw 4% of your portfolio. In the second and each subsequent year you withdraw the previous year dollar amount adjusted for inflation. The amount withdrawn, plus any other retirement income, becomes the amount to be spent in a calendar year.  Remaining assets will then grow or shrink according to asset returns for the year and your asset allocation plan. Remember, withdrawal rates are supposed to increase as we age and spend our nest eggs. The Rule considers historical market returns and applies to a specific portfolio composition, typically a 60/40 allocation, that carefully diversifies the portfolio across a wide range of asset classes and types of stocks and bonds. Adherence to the 4% Rule implies that one would have a low risk of outliving their savings over a 30-year retirement.  Critics of the Rule maintain that, depending on your age and health, a 30-year retirement planning horizon may not be needed or likely. As a long-range planning guide, the 4% Rule can provide an idea of how much savings may be needed in retirement. For example, if you intend to withdraw $25,000 from your savings in the first year of your retirement, you will need to have saved $625,000 ($25,000/.04).

So, does the 4% Rule still work? Yes.  However, it was never intended to be a steadfast rule, rather it is best used as a starting point or guide for planning your early retirement account withdrawals. The Rule depends, in part, on higher interest rates to generate income and cash flows sufficient in size to minimize the amount of reduction in account principal. Suffering a market downturn early in retirement means that you may have to withdraw from savings while your portfolio is incurring market losses.  (This predicament is referred to as sequence-of-returns risk which if faced in the early years of retirement can have an adverse impact on your sustainable rate of withdrawal.) Early followers of the Rule benefited from significantly higher interest rates than we currently see in the financial markets. In a time when yields are falling and stock market returns have become more uncertain, a better strategy might be simply to adjust your retirement withdrawals to match your life and portfolio investment performance.  This sounds straight-forward, but in practice can be challenging.  Develop a retirement plan and update it annually.  Make it a personal goal to be flexible in your spending. Adjust your spending based on market performance – spend a little less if the market is down and allow yourself to feel more comfortable spending a bit more if the market rallies.  Review your spending assumptions each year with the understanding that real lifestyle spending changes can be difficult to make. Recent studies suggest that taking a dynamic approach to spending in the early years of retirement can have a significant impact on the sustainability of your retirement portfolio.