The longstanding 4% rule was developed in the mid-1990s to answer the question, “How much can I safely withdraw from my retirement savings each year and have my nest egg last for the duration of my retirement?”
While this simple rule of thumb still stands strong despite numerous studies designed to prove it inadequate, it is important to understand the original assumptions that went into creating the rule and then take a modern view to get a more comprehensive answer to that important question.
In 1994, financial adviser William Bengen introduced the concept of the 4% rule, which found that retirees who withdrew 4% of their retirement portfolio balance, and then adjusted that dollar amount for inflation each year thereafter, would create a paycheck that lasted for 30 years.
Now 20 years out from the publication of Bengen’s study, experts recognize that this simple rule of thumb needs some modernization.
Big unknowns
The most significant issue with the 4% safe withdrawal rate is that there are just too many unknowns for the retiree: How long will you live? How will the financial markets perform? Where are interest rates and inflation rates going? What will your retirement expenses actually be and how will they change over time? What about your health care needs? How will your taxes be impacted by your retirement income? What about the Medicare surcharge?
These are all important pieces of the retirement puzzle to consider, as just a few wild cards can impair your income plan. That’s why modern times require a more dynamic approach to the 4% rule.
Questioning assumptions
It’s instructive to look at some of the Bengen study’s underlying assumptions to understand the problem with applying the 4% rate to retirement today.
First, let’s examine the assumptions it makes about market returns. Bengen tested a range of withdrawal rates on differing portfolios of stocks and bonds using inflation data and investment returns from the mid-1990s back to 1926. The rule uses a portfolio assumption of 60% stocks and 40% bonds. Historical bond returns for this period were close to 5%, well below what can be expected today. With increased volatility in both the stock and bond markets, taking a forward view of testing a variety of market conditions can help you better understand the longevity of your portfolio.
Another issue with the study is that it favors portfolio longevity as its primary objective, as opposed to income needs. But this approach doesn’t hold up if the sequence of your spending is heavier in the early years of your retirement or, inversely, if the market experiences a downturn early in your retirement. As such, numerous strategies have surfaced that are designed to explore ways to manage sequence risk, ranging from the bucket strategy (segmenting retirement funds into “buckets” based on time periods), to using a floor-and-ceiling approach (not withdrawing more than a well-defined ceiling or less than a well-defined floor, regardless of fluctuations in your portfolio’s value), to using lines of credit to help protect portfolio longevity.
Testing differing retirement income needs assuming the so-called “go-go, slow-go, no-go” pattern of retirement spending — that is, being quite active at the beginning of retirement and slowing down as the years go on — will help you better understand your portfolio’s longevity. The reality is, most people will need to adjust their withdrawals up or down as they move through retirement.
Lastly, the study assumes a simple approach to taxes that may have been appropriate at the time but does not stand up to the complexity of modern-day retirement. For many baby boomers, who make up a sizable contingent of today’s retirees, the composition of their retirement assets will have varying tax obligations, from fully taxable to tax-free. The tax code has also become more complex in how it taxes various sources of retirement income. For higher-income retirees, there is further complexity in managing the timing of income from qualified distributions, required monthly distributions (RMDs) once they reach age 70½, and Social Security benefits, and in managing the incremental impact on taxes at varying tax brackets, along with worrying about potential Medicare surcharge thresholds.
Taking a tax-wise lens to your withdrawal strategy becomes increasingly important as your wealth grows beyond the need to use Social Security benefits or qualified distributions. A recent study published by the Journal of Financial Planning examines the effects of Social Security benefits and RMDs on tax-efficient withdrawal strategies, concluding that you can improve portfolio longevity by using a dynamic approach to converting qualified assets to tax-exempt assets in some years and managing your qualified withdrawals to fully cover the standard deduction and max out the lower tax brackets in years where income is not needed.
Thinking beyond the 4% rule
Though the 4% rule has its flaws, it is still a reasonable starting point for retirement planning. So rather than regard it as unassailable truth, use it as a general means of assessing your savings level. For example, if you determine that you’ll need $60,000 a year to live comfortably in retirement, of which $16,000 will come from Social Security, you’ll be left with a $44,000 gap to fill annually. Using the 4% rule, you can multiply $44,000 by 25 to arrive at a $1.1 million nest egg, which is what you might aim for during your working years.
In this vein, households that have accumulated considerable wealth may use the 4% rule as a conservative yardstick. For most households, however, the rule is simply an opening bid. In reality, once you’re in retirement, you’ll likely need to make a year-by-year assessment on how to successfully manage your sources of income with both your spending needs and taxes in mind.
As the 4% rate faces the test of time, it’s clear that retirement readiness is too complex to be codified by a simple rule of thumb.
