Advisors have long recommended the 4% rule of withdrawing retirement savings but does it still apply?
How much should you spend in retirement to feel confident that your retirement savings will last?
For ages, the question was answered with the 4% rule but does it still apply in an age of rock-bottom interest rates and overvalued stocks?
Worse still, will the idea that you can safely withdraw four percent of your retirement savings leave you bankrupt?
Let’s look at where the 4% retirement rule came from, what it means in today’s markets and what you can do to ensure your retirement investments last as long as you do.
Where Did Advisors Get the 4% Rule for Retirement Savings?
The rule likely came from historical returns on fixed-income investments. Bonds have returned an annualized 4.3% over the last 20 years. That means you could have put all your retirement savings in the relative safety of the bond market, taken your four percent a year and still have had your principal.
The real value of your retirement savings would have declined because of inflation but you would still have the same nominal value if bond returns held up. Investing a small portion of your portfolio in stocks would have protected the account from inflation and you could have relied on the bond income during the periods of falling stock prices.
The 4% rule for withdrawals didn’t just affect how much you took out each year but many used it for an estimate on how much you needed to save for retirement.
If you’ve ever heard that you need 25-times your annual expenses by the time you retire, you were hearing an offshoot of the 4% rule.
The old school of thought was that the 4% rule of withdrawing from your retirement plans would virtually guarantee you could cover your expenses for at least 30 years. It’s generally described as giving you a 90% chance that you won't outlive your assets. In other words, in 90% of the projected outcomes in the models—and they are just that, projected outcomes—you’ll have enough money. In 10% of the projected scenarios this “4% plus inflation” spending plan would fail.
Does the 4% Rule Still Work?
With yields low and equity returns uncertain, some retirement experts now argue that the 4% rule as an initial rate of withdrawal for a 30-year retirement is too high. Instead, investors should spend less in order to give themselves the best chance to have enough to keep up with inflation and maintain their retirement lifestyle.
With even AA-rated corporate bonds only paying 2.8%, investors have had to go further into risky assets like dividend stocks to get the return they need to support the 4% retirement rule.
As stocks touch all-time highs and valuations not seen since the tech bubble, many are forecasting much lower returns over the next ten years. Vanguard founder Jack Bogle has said bond returns will likely not beat 3% and stocks may only provide a 5% or 6% return over the next decade.
That means withdrawing 4% a year from your retirement savings could leave you out of money much sooner than expected.
On the other hand, others argue the 4% rule is too low. You really should be able to spend more early in your retirement when you’re most able to enjoy it, and worry less about whether you’ll have enough to spend the same amounts later. Also, do you really need to spend less now to give yourself a high level of confidence that you’ll have enough 20 or 30 years from now?
Tips on Beating the Four Percent Rule
I’ve got a love-hate relationship with these investing rules-of-thumb. On the one hand, they are easy and allow anyone to plan their own retirement.
The downside is that they may be completely inappropriate for your investing needs. Investing is much more personal than most people know. Your investment plan needs to start with YOUR goals and risk tolerance rather than a back-of-the-envelope guess.
There are a few things to remember if you are going to follow the 4% rule of retirement planning:
- Have a retirement plan and update it regularly. Start with creating an investor policy statement around your goals and investing needs. This is going to give you a customized idea and help you pinpoint exactly how much you need; update this plan every year. The 4% rule may be applicable for a retiree who's 65 and expects to live 30 years in retirement but your age and personal circumstances may be different.
- 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 does better than expected. You won't want to take this too far, though. The good days in the market tend to even out the bad days over time.
- Consider insurance to help cover essential expenditures. One of the most common, but also underappreciated types of insurance for retirement, is a low-cost annuity, either a variable annuity, possibly with an optional living benefit (or “income” benefit), a single premium immediate (fixed immediate annuity), or both.
Annuities won't make sense for everyone. Some investors just may not be comfortable with annuities, either due to the complexity or costs. But they are one of the few forms of investments that have insurance features plus an income that you can’t outlive (subject to the financial strength and claims-paying ability of the issuing insurance company).
An annuity and Social Security can help increase your confidence in a sustainable spending rate by providing a source of guaranteed lifetime income. With an ongoing stream of payments, you can feel more comfortable that, even if you outlive your portfolio, you’ll have a source of income to cover essential expenses in retirement.
If you’re worried that the 4% rule may no longer apply, start by lowering your expectations on market returns and see where your current investing plan gets you by retirement. Rather than increasing your risk into stocks or high-yield bonds, look closely at your spending. Losing a big chunk of your nest egg early in retirement due to a stock market crash will cause you to cut even deeper than if you had kept spending under control.
Final Thoughts on the 4% Rule for Retirement Spending
Whether you follow the 4% rule for retirement spending or a more personalized approach, it’s important to update your plan regularly and check it against market returns. This will help you adjust as quickly as possible so you don’t run the risk of financial ruin later in life.
About the Author
Joseph Hogue is a financial expert and investment analyst. After serving in the Marine Corps, he started his career investing in real estate before becoming an investment analyst for some of the largest private investors. He's appeared on Bloomberg and on CNBC as an investment expert and has published ten books in personal finance. Now he helps investors reach their financial goals and invest in the stock market with some of the same advice he used when working for the rich.