Is the 4 percent withdrawal rule safe?
That's a great question.
It is one of the most debated and talked about concepts in the personal finance world.
In this post, I'll tell you where the concept originated.
I'll point you to the latest research on the topic.
And, most importantly, I'll tell you whether the rule is still relevant in today's low-interest-rate environment.
The 4 percent withdrawal rule defined
The 4 percent withdrawals rule, also called the 4 percent rule or the safe withdrawal rate (SWR) refers to the amount of money you can “safely” withdraw from your retirement accounts without running out of money.
We will start with these three.
- The starting value of your portfolio
- An assumed return on the portfolio
- A life expectancy factor
Let's say you have a $1,000,000 portfolio of stocks and bonds. The 4 percent rule means you would take out $40,000 annually for income. The assumption is that your investments would earn a return higher than 4 percent (on average) to maintain your principal through retirement.
I'll talk more about the problems with this later. For now, these are the basics.
The origin of the 4 percent rule
The rule originated with a 1994 article by William Bengen. The title of the paper was Determining Safe Withdrawal Rates Using Historical Data.
Mr. Bengen used historical market data for 30-year rolling periods. He wanted to focus on how the severe market downturns of the 1930s and early 1970s impacted portfolio withdrawals.
The study determined that the 4% withdrawal rate was a sustainable withdrawal percentage to maintain the income level over a 30 year period without depleting the portfolio.
A study by three professors from Trinity University in San Antonio, TX updated the Bengen study in 1998. For the most part, the Trinity Study affirmed Mr. Bergen's previous work. Researchers often call the study the 4 percent rule.
Both studies assume the percentage that's withdrawn each year adjusts for inflation. Both studies show this strategy offers the best chance for an individual not outliving their money.
The study initially assumes an investment allocation of 50% in the S & P 500 and 50% in intermediate-term government bonds. He also tests stock allocations of 25%, 50%, 75%, and 100%.
As you would expect, the larger stock allocations offer better longevity.
The results come from the historical past market returns from 1925 to 1994.
The idea was to include several severe market events (depression, several significant market downturns) to see how/if that impacted the results.
The study looked at 30 year rolling periods to come up with the results.
The 4 percent number was what the study indicated would sustain the portfolio throughout a 30-year retirement.
The 4 percent is a rule of thumb
You should view the rules of thumb as a starting point in most things.
When talking about the success of your retirement, it most definitely applies.
Earlier we mentioned the three factors (starting portfolio size, assumed return rate, life expectancy) to consider when using the 4% rule.
Many other factors can derail the plan. Things like:
- Higher than expected inflation
- Lower than anticipated interest rates
- Lower than expected stock returns
- Higher than anticipated retirement expenses
- A catastrophic health event
Let's break down the three mentioned earlier one by one.
Starting portfolio value
I showed you how to calculate the income generated from a 4% withdrawal rate from a $1,000,000 starting point. That's pretty simple math, right?
So, how do you determine how much income you will need in retirement if you're ten or twenty years away?
First, decide on the calculation method for determining income need. There are many options. I'll focus on two of the most popular.
The most common uses a percentage of your current income. The rule of thumb here is to plan to provide 70% – 80% of your current income.
So if you currently make $100,000, you would prepare for a retirement income of $70,000 to $80,000.
Another method is to calculate the income need based on current expenses. Many feel using this method is more accurate. Computing retirement income as 100% of current monthly costs is considered a more conservative way.
I tend to be conservative when doing this math. So, I would use this method.
Whatever method you choose, you must calculate the desired income into a starting portfolio value. Once again, there are problems with this method. For now, we'll keep it simple.
Let's say you need a retirement income of $70,000 and you're going to retire at age 67. You want to plan for a long life expectancy to be even more conservative. Let's say that's age 92. That means your income needs to last for 25 years.
The 4 percent rule says you would need $1,750,000 to provide that income without eroding your principal.
If you have investment accounts (taxable, IRA, 401(k), etc.) totaling $750,000, you need to save another $1,000,000 to make up the difference.
If you're currently age 50 that means over the next seventeen years, you'd need to sock away $35,445 a year earning 6 percent to make up the shortfall.
And this average return in the example is a constant 6% per year. It doesn't account for any market fluctuations.
You see the difficulty in the calculation?
Unless you want to leave a considerable legacy, why calculate maintaining your principal value to the end?
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The assumed rate of return
The assumed rate of return is where it gets tricky. Performances in the study may not reflect the returns in the future.
One major factor is that bond yields have been substantially lower in recent years than in the past. The current ten-year Treasury rate is just under 3%. Though the Fed is in a rate raising posture, it's unlikely to go back to the levels of the late 1970s and 1980s.
Some of you remember those days. Interest rates and inflation were in double digits for much of the decade. That skews the return number considerably.
Back then, people retiring could live off the bonds and fixed income investments like CDs. When you could take out double-digit incomes, it seemingly made retirement planning more manageable.
The problem was inflation was just as high. So, the buying power of the money diminished due to much higher inflation.
Since the financial crisis of 2007- early 2009, interest rates have been near zero.
That means to replicate the kinds of returns needed you'd have to have more money invested in stocks. At retirement, many people want to reduce the amount in equities to reduce the risk of their investments.
However, to maintain buying power and generate the returns necessary to make their money last, many retirees have more money in stocks than they want.
Dividend yields on the S & P 500 are around 2.2 percent or so. That's well below the 4 percent SWR.
The days of living off the interest are gone and likely not coming back any time soon.
The total return approach is how most retirees are getting the income they want.
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Life expectancy is a crucial factor.
Plan for one that's too long, you risk living on less than you might want or need.
Plan for one that's too short, you risk running out of money.
My advice is to err on the side of caution. It's much better to plan for a longer than expected life than to risk running out of money because you didn't.
So, what's the age to use?
Recent studies show that there is close to a 50% chance that one person of a married couple age 65 will live to age 92. So, to me, that's the starting point.
Many use age 95 or even age 100. That may sound crazy, but with advances in health and health care, we are living longer than at any time in history.
If you're a woman, on average, you will live from five to seven years longer than men.
Remember, the SWR is a rule of thumb. It provides a way to keep your original starting principle value intact. There is plenty of flexibility in the calculation to adjust spending and income along the way.
Get better returns on your money? Great. Take more income that year.
Get worse returns? Cut back.
Be flexible and willing to make adjustments.
Problems with the rule
Financial and retirement planning should be about your goals. For some, leaving a substantial legacy is a stated goal.
In that case, the 4 percent rule which preserves and, in many instances, grows your capital, makes sense.
For others, that's not the case.
Here are a few of the variables that can cause the 4 percent rule to fail.
According to a recent Fidelity study, the average American will spend $280,000 in health care costs. This MarketWatch article, Healthcare will cost $280,000 in retirement – and that doesn't include this huge expense, highlights the study's main points.
What's that “huge” expense? Long-term care costs.
According to LongTermCare.Gov, in 2016 the national average price of a semi-private room is $225 a day. That's roughly $6,750 monthly or over $82,000 a year.
So a one-year stay in a long-term care facility adds another $82,000 to the $280,000 total.
Even cutting the long-term care costs in half, the total healthcare bill rises to $321,000. For a thirty-year retirement, that's an additional almost $11,000 a year expense. And that's just for one person. If married, this potentially doubles.
For a 25 year retirement, the cost increases to between $13,000 – $26,000 annually.
Many retirees will have difficulty coming up with an additional $1,000 to $2,000 or more a month!
Required minimum distributions (RMDs)
Many people at or nearing retirement have significant amounts in traditional IRAs or employer retirement plans.
For most, they have been the best options for socking money away for retirement.
For those with large balances in these accounts, you likely know that the IRS requires you to begin taking that money out at age 70 1/2.
Depending on the size of these accounts, and how long you live, RMDs may require you to withdraw much more than 4 percent.
There are ways to minimize the impact of RMDs.
First, determine a projected account value at age 70 1/2. If you're a regular reader of this blog, you know I recommend Personal Capital for these kinds of things.
It's a free tool can help you project these values and come up with a strategy specific to your situation.
Here are a couple of ways to minimize the impact of RMDs.
- If you're over age 59 1/2, begin withdrawing from these accounts early. Reducing the amounts in the plans at 70 1/2 offers more control over when and how you take income.
- Consider converting some of these funds to Roth IRAs. It's not necessary to convert them all at once. You can make partial withdrawals yearly. Keep taxes minimized by converting just enough to keep you from going into a higher tax bracket.
Of course, there are other things to consider with this strategy. If you're taking Social Security, additional income may increase the taxes you pay on your Social Security benefit. You have to look at the total picture when deciding how to take your income.
If this strategy works for you, the result is you will have less money in taxable IRAs when you have to begin withdrawing. You also have more control over how and from what sources you take your income.
Other sources of retirement income
The SWR doesn't consider what other sources of income you might have.
These days, many retirees continue to work part-time in retirement.
Two other sources of income are Social Security and pension.
Less than 10 percent of private companies still offer pensions. So, for most, this isn't an issue.
In my area, however, the government is the biggest employer. As such, pensions are a big part of retirees income.
Though there is much hand-wringing over whether Social Security will be around, I'm convinced it will be.
As dysfunctional as Congress can be, no one wants to be known as the person who gutted Social Security. If history repeats itself, they will swoop in at the eleventh hour and implement a fix.
To calculate how much income your investments need to provide, subtract all other sources (income from work, Social Security, pensions, real estate) from your desired income. Divide that amount into your portfolio value to determine your withdrawal rate.
For example, if you want $100,000 in income, and your combined household income from Social Security and part-time work is $65,000, your investment would need to provide the other $35,000. If your investment accounts total $1,000,00, that's a 3.5% withdrawal rate.
Consider all the variables when calculating.
Using the 4 percent rule as a starting point is a good exercise. It's great for getting a ballpark figure of how much money you need to get you through retirement with the income you want.
It isn't a be all end all solution for most people.
If you start calculating early and use tools like Personal Capital or work with a competent, independent financial advisor, you can put a plan in place to put you on a track to have the kind of retirement income you desire.
If you want to leave a substantial legacy for your family, church, or other charities, accumulating the capital to support the 4 percent withdrawal and maintain or grow your principal is a good strategy.
Even then, though, the variables along the way may require adjustments. Things like inflation, interest rates, market returns, unexpected healthcare expenses and other unforeseen events often need adjustments.
Why should we expect retirement to be any different than pre-retirement concerning unexpected events? We shouldn't.
Be flexible. Understand it's a dynamic process. Use the SWR in a way that fits your situation.
Tell me what you think.
Is the 4 percent rule something that will work for you? What obstacles are in your path? How can you overcome those obstacles? How are you preparing for retirement?
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