Retirees are learning there’s no magic in the magical 4% Rule. For years financial advisors touted this as the safe rate of withdrawal from retirement funds. For many people, it’s not looking so safe now. Fortunately, there are alternatives that have more reliable results.
The 4% Rule states you can withdraw about 4% of your investment funds in the first year of retirement. After that, you can add 3% inflation to the previous year’s withdrawal and continue this practice the rest of retirement. Following this policy through retirement means you’re unlikely to run out of money by the end of a 30-year retirement. Retirees are learning the rule is not as safe as they thought. That’s because they overlooked some assumptions used in developing the rule and some details in its conclusions.
The studies that developed the 4% Rule assumed a portfolio is 60% invested in the S&P 500 and 40% in a bond index. Many investors, often without realizing it, had riskier portfolios than this, so they had steeper losses in the financial crisis. The rule also assumes your portfolio allocation doesn’t change. Many people shifted to more conservative portfolios near the worst phase of the crisis, so their portfolios didn’t recover as much as the model portfolio did.
The 4% Rule never said you’ll never run out of money. Studies that developed the rule used Monte Carlo analysis, which calculates the results over a wide range of possible scenarios. Most studies found the 4% rule left you with enough money 90% to 95% of the time. That means you’d still run out of money 5% to 10% of the time. Most people thought they were safe following the 4% Rule. They thought, “What are the odds I’ll be caught in one of those historically bad situations?” It turns out the odds were 100% for this generation.
Another oversight was that the 4% rule carried calculations only to 30 years of retirement. That’s too short a period for many retirees, especially married couples.
Following the rule also assumes you’ll have the confidence market returns will rebound to result in the long-term average over your lifetime and will stick with the plan. During the low points in the strategy, it’s tough to keep drawing out money and hold your portfolio allocation steady when recent returns are low and almost all forecasts are for low returns going forward.
Investment returns are not static. While the long-term return from stocks is around 9%, there are few years when the indexes return 9%. Most of the time returns are dramatically higher or lower than the average. Also, there are extended periods during which returns are significantly higher or lower than the long-term average.
Markets are dynamic, and your retirement spending and withdrawal strategy also needs to be dynamic. There are different ways to adopt a dynamic “cash out” strategy that will greatly reduce the probability you’ll run out of money and will increase the potential to leave something for your loved ones and charity.
The easiest way to modify the 4% Rule is to eliminate the automatic 3% inflation increase each year. After a year of bad investment returns, suspend the annual increase for three to five years to get things back on track. This inflation increase is a very expensive part of a retirement plan. During the early years of retirement, it’s a good idea to avoid the automatic inflation increase even when markets are good to build a cushion against major market losses.
You can take a stronger step. Actually reduce spending after a period of subpar investment returns. Most people’s budgets have some flexibility. You can dine out less, travel less, postpone some purchases for the home or to replace a vehicle, and so forth. It’s not what we intended for those post-career years, but it’s better than putting financial independence at risk. T. Rowe Price issued a study recently in which it concluded that the best way to get a plan back on track after a severe bear market is to reduce the distributions by 25% and hold that level for three to five years.
Examine your investment strategy as well. Resist the natural impulse to hunker down in cash after a market decline to preserve what they have left. Instead, consider two other strategies.
Review your portfolio to determine if it is sufficiently diversified. As we’ve discussed in past visits, most buy-and-hold portfolios are too closely tied to the stock indexes. You need a portfolio with true diversification, such as our “hedge fund” mutual fund portfolio. Such a portfolio grows steadily during good times and holds much more of its value much better during tough times.
An alternative is to make your portfolio, or at least part of it, more dynamic. You could follow one of our Managed Portfolios or the Retirement Paycheck Portfolio, so the portfolio allocation isn’t locked in during a poor investment period. You also might want to put 5% to 10% of your investments in our Invest With the Winners Strategy, so it’ automatically adjusting to market changes.
There’s one more strategy to consider. I always recommend retirees consider a version of the Yale Endowment spending policy instead of the 4% Rule. This policy automatically adjusts distributions for changes in the portfolio and inflation. But the formula ensures the changes are gradual. It’s explained in detail in my book, The New Rules of Retirement, but here’s a capsule.
First, you decide on the safe withdrawal rate for you. Let’s say you choose 4% of the portfolio the first year plus an increase of the actual Consumer Price Index in subsequent years. Then, you decide what portion of annual distributions should be based on this formula and which portion should fluctuate with the portfolio. Let’s say you decide 70% of distributions should be based on the safe withdrawal rate and 30% on the portfolio’s value. To keep it simple, we’ll say your portfolio is $100,000. Here’s how it works.
The first year you withdraw $4,000 (4% of $100,000). If inflation is 2% after the first year, the safe withdrawal rate distribution is $4,080 ($4,000 plus 2%). You calculate 70% of that as $2,856. Suppose after the first-year distribution and investment returns, the portfolio ends the year with a value of $105,000. You calculate 4% of that as $4,200, and 30% of that is $1,260. Adding the two components gives you a second year distribution of $4,116 ($2,856+$1260). That’s an increase of $116.
This formula allows spending to increase gradually during periods of good returns and decline gradually during poor markets. Likewise, distributions increase gradually as inflation rises.
A retirement plan is a process, not something that’s locked in. A plan is based on assumptions and forecasts, you adjust it as real world results come in and differ from the forecasts and assumptions. That’s the best way to avoid running out of money and increase the odds you’ll be able to leave something for loved ones and charity.
RW May 2011.
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