Home Personal Finance Forget the 4% Rule: Here’s What You Should Really Be Looking at During Retirement

Forget the 4% Rule: Here’s What You Should Really Be Looking at During Retirement

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Retirement-minded investors have likely heard of the so-called “4% rule.” Indeed, current retirees may well be utilizing the rule, which determines how much of your retirement savings you can spend every year without outliving your money. And as far as rules of thumb go, it’s not a bad one to embrace.

If you think the rule is bulletproof, though, think again. There’s another way of thinking about preserving your savings through your retirement that could prove more realistic and more beneficial.

What’s the 4% rule?

Never heard of it? It’s simple enough. The 4% rule says that in your first year of retirement, you can withdraw 4% of your total retirement savings and then raise that amount every year by the annual rate of inflation without outliving your money.

For example, if your portfolio is worth $500,000 when you retire, you can spend $20,000 of it during the next 12 months. If the inflation rate during that stretch averages 3%, the next year’s withdrawal is upped by 3% to $20,600. That math is then repeated each subsequent year.

There are some important assumptions to note about the rule. Chief among them is the underlying investment portfolio’s mix. The 4% rule presumes half of your retirement savings is held in stocks for the entirety of your retirement, while the other half comprises bonds and other fixed-income investments. The rule also assumes you’ll achieve average returns on both categories of assets.

Also, know that in this particular case, “lifetime” actually only means 30 years of retirement, at which time, your portfolio is apt to be depleted. It just so happens that when financial advisor William Bengen came up with the 4% retirement rule back in 1994, it was highly unlikely anyone would live that long beyond the onset of their retirement years.

And there’s the rub … several rubs, actually. The rule of thumb was developed at a time when things were dramatically different from the way they are now. People are living longer than they used to, and perhaps worse, the stock market is much more volatile than prior to 1994.

As market analytics outfit DataTrek explains, “From 1958-1979, the standard deviation of daily returns was 0.72 percent. It rose to 0.89 percent from 1980-1989, and has been even higher since 2000, at 1.13 pct.” This can rattle retirement plans when you’re living off retirement savings that must also continue growing.

And if it feels like the market’s swings from peaks to troughs (and vice versa) are more pronounced and longer-lived than they’ve been in the distant past, you’re not imagining that either. They are. That’s why you might want to look at your retirement spending plans from a different perspective.

2 other criteria to consider

The thing about rules of thumb is they’re not tailor-made for a specific person or situation. They’re a starting point but not necessarily where the effort should stop. That’s especially true of retirement planning.

So, if not the 4% rule, what should people really be looking at during retirement? Two things stand out among the rest. The first is achieving consistent, absolute net returns, even when the market itself isn’t making it easy.

Investors understand that stock market returns fluctuate from one year to the next, but given enough time, it will dish out average annual gains of around 10%. Half of Bengen’s hypothetical portfolio, however, consists of bonds and fixed income. Meanwhile, interest rates on bonds lingered at multidecade lows between 2009 and 2021, dragging down their overall net returns for that span of time.

Data by YCharts.

This prolonged, subpar performance from the fixed-income piece of Bengen’s model portfolio would have crimped the portion of it intended to provide more reliable returns when stocks aren’t performing so well. Without a solid fixed-income backstop supporting the 4% withdrawal paradigm, one’s retirement savings could be depleted sooner than the expected 30 years.

In this same vein, Bengen’s model may pose problems because the equity half of his hypothetical portfolio could also underperform for long periods. Prior to 1994, the last time the S&P 500 had lost ground for any 10-year time frame was all the way back in 1941. Then, 2008’s subprime mortgage meltdown happened.

Already walloped by the dot-com implosion of 2000, it wasn’t until 2013 that the index could finally move above its mid-2000 peak. Again, ever-rising withdrawals from a 50/50 portfolio would have prematurely reduced that portfolio’s future net growth.

And the second thing retirees will want to keep close tabs on once they begin selling and spending chunks of their portfolio? The impact of rising expenses. You know it better as inflation.

Retiree worried about outliving his retirement savings due to rampant inflation.

Image source: Getty Images.

Bengen’s 4% rule is based on prior decades when inflation was mostly tame. While inflation climbed through the roof between the late 60s and early 80s, that time frame was paired with ultra-high interest rates on bonds and other fixed-income investments. The bond and fixed-income half of a portfolio would have more than fully funded the 4% withdrawal rule through such a stretch. Indeed, bonds dished out better returns than stocks did during that time.

Above-average inflation has been a problem the past few years, but investors are still not yet benefiting from above-average interest rates that help to offset the higher expenses. Most retirees can’t afford for this dynamic to become the norm.

In other words, your portfolio doesn’t just need to be capable of producing consistently adequate returns. It must be capable of doing well enough to also fully offset inflation’s impact — even just temporary surges in inflation — which are felt before the following year’s withdrawal amount is calculated.

Consider everything in a constantly changing environment

Making the appropriate adjustments to your retirement portfolio is easier said than done. Sometimes, the market simply doesn’t cooperate. Other times, it might offer what’s required but only by adjusting your allocation in a way that could feel inappropriate for a retiree … like acquiring stakes in inflation-hedging commodities such as gold. Just don’t be too quick to mindlessly make moves to solve one problem that might create another.

Instead, accept this reality: While all plans should be simple enough to consistently follow, the 4% retirement withdrawal plan may be too one-dimensional in the modern market environment. That’s the case, even though Bergen updated the rule in 2001 to make the calculations of withdrawals more flexible, adjusting for possibilities not initially considered likely. Retirement portfolios and withdrawal plans must be regularly reevaluated from top-down and bottom-up perspectives with current conditions in mind. There’s no magic formula to any of it.

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