Does the 4% Retirement Rule Still Hold Up?
One of the most prevalent rules of thumb in personal finance is the 4% withdrawal rate. This was coined by financial planner William Bengen in the mid 90’s when he found that over every rolling 30-year period since 1926, retirees holding a 50/50 split of stocks and bonds could safely have withdrawn 4% of their starting portfolio assets each year while adjusting them for inflation. Last month, a report from Morningstar questioned whether that rule of thumb still applies in today’s conditions.
Here’s a quick example to clarify the 4% safe withdrawal rate rule of thumb. Our recent retiree has saved up a retirement nest egg of $1,000,000. From this, according to the 4% rule, the retiree could expect to withdraw $40,000 in year one ($1,000,000 x 4%). This amount would then be increased by inflation year over year. So, in year two of retirement, our retiree withdraws $41,000. In year three, $42,025 and so forth. Bengen’s 4% withdrawal rate states that these portfolio withdrawals could be made over the course of a 30-year retirement without the retiree running out of money.
It surely comes as no surprise that the current state of our financial markets has the industry questioning many longstanding ideas. The 4% rule has come under scrutiny due to two major factors. Current bond yields and current market valuation.
Current Bond Yields
The chart above shows the yield on 10-year treasuries since 1921. The current yield of 1.58% is not only far below its 100-year historical average of 4.78%, it is also around the lowest point of all time! With 50% of our retiree’s retirement nest egg allocated to bonds, starting a retirement at these low levels is not ideal. Bond yields and bond prices move inversely with each other. That is to say, when yields go up, bond values go down. While bond yields may stay at these low levels for an extended period of time, it’s very likely that they will eventually move higher which will negatively impact the value of the bonds held in our retiree’s portfolio.
Current Market Valuation
In this next chart, we are examining the “Price to Earnings Ratio” -or P/E- of the S&P 500 over the last 100 years. Put simply, the P/E ratio describes how much a potential shareholder is willing to pay for each dollar of a company’s earnings. Due in part to the low bond yield just covered, the S&P 500 has become very expensive relative to the earnings of all the companies within the index. Many in the financial planning industry view this level as difficult to maintain and that, at some point in the future, we may face a period of lower average returns.
Considering these two major factors, the Morningstar report has concluded that -given the same assumptions as Bengen used when he demonstrated the 4% rule- a retiree today could only expect to withdraw an initial amount of 3.3% of their retirement savings. While this may not seem like much, remember that these retirement distributions must increase with inflation. Using the example $1,000,000 portfolio from before, a 4% starting point gives our retiree 21% more in year five than a 3.3% starting point after five years of inflation increases. This difference will only grow over time.
These issues that are unique to today’s retirees have complicated the retirement planning process but there are options to consider that can maximize the amount distributed from retirement assets while minimizing the chance that a retiree outlives their money.
Diversification and Risk Management
The 4% rule assumes a simple, US centric 50/50 stock bond split. Adding diversification and risk management your portfolio is one method that can create a more durable retirement portfolio that has the potential to weather the headwinds discussed so far.
Bengen assumed that once a retiree began distributions, they would keep to that amount increased by inflation. A retiree could develop a plan in which market performance would dictate spending.
Social Security Planning
Social Security is one of the few sources of guaranteed income available that also increases with inflation. Proper Social Security claiming strategies that consider current and future expenses can extend the life of a retiree’s nest egg.
Using More Advanced Retirement Projections
While developing the 4% rule, Benson looked back at each rolling 30 year period since the 1920’s and overlaid his withdrawal assumptions on top. Today’s financial planning involves extensive use of Monte Carlo Analysis. Now, instead of looking to one reality of the past, financial planners use thousands of potential future possibilities. From those projections, we can derive the probability of a successful retirement tailor made for each client instead of a blanket recommendation.
At Innova Wealth Partners, we use these tactics and more to help our clients maximize their retirement potential. Email me at firstname.lastname@example.org if you’d like to learn more about how these methods could help you reach your own retirement goals.
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