You’ve likely heard of this rule: retire at 65 and withdraw 4% in the first year of retirement, add a cost-of-living adjustment annually to account for inflation, and you are golden in your golden years. In short, your retirement and investment assets should last for the rest of your life.
We generally assume a life expectancy to age 90, which is widely used in financial planning. This 4% rule is supposed to represent a “safe” withdrawal rate of retirement income and provide comfort to retirees knowing their assets will not be depleted before their hourglass of time runs out.
The History of the 4% Rule
The 4% rule was the conclusion of extensive research conducted by a highly regarded financial planner, William Bengen, in 1994. Bengen explained that when he began working in the financial services industry in the early 1990s, his clients continually asked two questions:
How much should I save for retirement?
How much can I spend in retirement without running out of money?
He courageously admitted he had no answer for either question but did have the determination and curiosity to find one.
Bengen analyzed retirement for each year from 1926 to 1976, basing his calculations on a moderate risk allocation of 50% large company stocks and 50% intermediate term bonds and annual rebalancing of the portfolio back to the 50/50 target allocation. In the end, the 4% calculation was deemed to be the highest withdrawal rate that could both last through retirement (in Bengen’s case, defined as 30 years) and withstand various economic conditions and market cycles.
Factors Affecting the 4% Rule’s Effectiveness
Additional Income Streams – Including Pensions and Social Security Benefits
There are countless other variables that factor into this discussion:
Will you or do you have pension income that will help to cover some of your retirement expenses?
Is your pension structured to cover you and your spouse (if you are married), or does it cover a single life only?
Should you begin collecting Social Security benefits sooner or later than your full retirement age, and will this have a positive or negative impact over the long haul?
Economic conditions and stock market and bond market performance could also influence the sustainability of this withdrawal rate. Additionally, given the 4% rule is adjusted each year for inflation, another period of high inflation, as experienced in the 1980s, could be stressful for retirees using this rule for withdrawals to meet cash flow needs.
Age of Retirement, Particularly Early Retirement
Early retirees would likely need to make adjustments to the 4% rule in order to mitigate the greater risk of running out of money. Some research indicates that 3.5% is a safer withdrawal rate for those retiring before age 65, due to the longer period needed to stretch their available assets.
Health Care Costs
Early retirees may also have to consider added costs of health insurance and out-of-pocket medical expenses in their budgets prior to enrollment in Medicare at age 65. Unanticipated health expenses or long-term care expenses can present stress to a family budget. This situation could be especially detrimental in the context of early retirement coupled with significant long-term care expenses.
Sequence of Investment Return Risk
What if the first year or two in retirement coincides with a declining stock market and your account values drop? This may introduce emotional or behavioral considerations. Will you stay invested in your target allocation even when the markets are going in the wrong direction? It takes discipline to “stay the course,” especially in a bear market when it can be tempting to move away from your target until the markets “stabilize.”
This is where a financial professional can provide value, perspective, and maybe even coaching to keep you invested in your target allocation during volatile and declining market cycles. The history of capital markets has proven repeatedly the adage that investment success usually results from “time in the market” and not “market timing.”
Family health history can seriously lengthen or shorten one’s “retirement zone.” Some family members may live up to or beyond age 100, while others could pass away well before the typical 90-year life expectancy.
Personal lifestyle factors also have significant bearing on success or failure of the 4% rule. Smoking, exercise, diet, stress, or overspending are just a few examples. In some cases, individuals are more focused on leaving a legacy or charitable intentions than on financial goals.
A Good Guide, Not a Golden Rule
So, can we still rely on Mr. Bengen’s 4% theory? Could we ever rely on it at all? Is this something else to add to a lengthy list of things changed by the COVID-19 pandemic? You may have heard recent reports that due to the pandemic, life expectancy in the U.S. has shortened by one full year.
In the end, the 4% rule should be used only as a guideline for retirement. There are certainly no guarantees this is a safe withdrawal rate for all retirees. This rule is perhaps best used as a starting point for a conversation or analysis of a comfortable lifestyle, based on personal situation, risk tolerance, family history, and life planning goals.