Nothing appeals to investors like a simple rule of thumb. Who doesn’t want a blanket strategy that applies to everyone and solves everyone’s problems? Enter the “4% Withdrawal Rule.” Let’s quickly discuss the genesis of the 4% withdrawal rule and then to the trenches to see if it still applies in today’s capital market environment.
Coined by financial advisor Bill Bengen, the 4% withdrawal rule originated in the early 1990s. Bengen’s thesis stated that if a person were to withdraw 4% of retirement savings each year, adjusted for inflation, the funds would last 30 years (or more). This conventional wisdom has come into question recently in today’s low-yield environment. When the formula was introduced in the early 1990s, it was designed to accomplish a fixed rate of withdrawal, like an annuity. It was also to minimize the risk of a retiree running out of money. Keep in mind that when the rule debuted, the yield on a three-month Treasury Bill was 6 percent. Even in 2002, the five-year U.S. Treasury Note still yielded 4.5 percent.
In most cases, the rule still makes sense. That said, it should be used as a general guidepost for decision-making, not some sort of immutable law that will work under any circumstances. Let’s assume the average retiree has a balanced portfolio of 50% equity investments and 50% fixed income investments. Then, in theory, assuming long-run historical average returns continue in the future (conservatively speaking, approximately 9% for diversified equities and approximately 4% for diversified fixed income), not only will a person not run out of money, but the portfolio will grow over the years.
A quick example will help to illuminate this point. Mary retires at age 65 with $1,000,000 in her portfolio. She distributes $40,000 per year, adjusted for inflation, and the long-term average growth of her portfolio is 6.5% per year. In year 1, she distributes $40,000, which leaves her with $960,000. However, that $960,000 is growing at 6.5%, so this leaves her with $1,022,400 at the end of year 1. Each year, for about the first 15 years, her portfolio is effectively growing by $20,000+, in nominal terms. As inflation increases Mary’s yearly distributions, the overall growth of the portfolio begins to slow, but nevertheless, the $1,000,000 portfolio on 01/01/2016 grows to slightly more than $1,500,000 as of the end of year 30 (12/31/2045).
However, a small tweak to the asset class returns would yield vastly different results. For instance, assuming equity returns of 8% and fixed income returns of 3% over the long-term would yield an ending portfolio balance of $668,261. Obviously, a far cry from the $1,518,063 mentioned above. As is the case with financial models, the model is only as accurate as the inputs used.
Also, a weakness of the above example is that straight-line growth was used for the portfolio returns. With the lumpy returns that we experience in the capital markets, we know that portfolios do not grow in straight lines. Unpredictable capital market returns speak to the fact that withdrawal rates should be monitored continuously. “Setting and forgetting” is not a good strategy when it comes to portfolio distributions in retirement.
Another aspect often lost when discussing the 4% withdrawal rule is the number of variables that have significant impact in the calculation. When one retires is a major variable. Someone retiring at 55 most likely has a much different sustainable withdrawal rate than someone retiring at 70. The impact of inflation is another crucial variable. The prevailing interest rate environment has a dramatic impact as well. And, as previously mentioned, capital market volatility has tremendous influence that has to be taken into account.
Ultimately, the biggest incongruity about the 4% withdrawal rule is the fact that it has “rule” in its name. Calling it the 4% withdrawal “guidepost” or the 4% withdrawal “plan” would help in matching up theory with reality. Of course, saving more during one’s working years and using diversification to lower the volatility of one’s portfolio will also help from depleting all of one’s assets during retirement years.
In summary, staying flexible during the distribution phase of one’s life will increase the probability of a successful journey through retirement. Feel free to start off your retirement using the 4% rule as a guidepost with the willingness to change course if things work out better or worse than expected. If things don’t go as well as planned, consider skipping a cost of living increase during the lean years. Also consider resetting your spending at a slightly lower percentage, such as 3.5%, or potentially withdrawing 4% of the lower value in your portfolio.