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Good News For Retirees Seeking Consistent Income: The 4% Rule Of Thumb Could Now Be 4.5%

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There’s huge news in the world of financial planning if you ask me. If ever there was a viral news story in my profession, this could be it.

Rarely do we get a piece of breaking news in our arena; we instead get the opposite of flashy reporting, with developments in financial planning happening at a glacial pace. If things do change quickly — like when the maximum annual contribution amount to your 401(k) goes up by $500 — the news rarely makes headlines.

So, what’s this Big News? The financial planning gospel has changed. According to Barron’s, a long-held guideline on annual retirement nest egg withdrawals has been upended by its creator. The article’s title is “The Originator of ‘the 4% Rule’ Thinks It’s Off the Mark. He Says It Now Could Be Up to 4.5%.”

One-half of a percent may not seem like much, but it could be tremendous news. This bump gives retirees a hefty increase in purchasing power when we look at the math below – a 12.5% boost, to be exact.

4% on $1 million = $40,000

4.5% = $45,000

So, the additional $5,000 is 12.5% more than $40,000

This development might mean you can retire months or even years ahead of your current schedule.

Think of all the major considerations at play during retirement planning and when you begin the post-career phase of life. There’s how much money you have today, how long you intend to keep working, how much you’re saving every year, the issues of inflation and rates of return, and how much you can withdraw each year.

The 4% Rule has long determined this last piece. While naysayers have challenged this guideline, it’s held up over the years for investors who have about 50% to 75% of their portfolio in stocks and the rest in bonds.

Let me start by explaining the 4% Rule’s origin, how it works, and some of the controversy surrounding the concept.

In 1994, William Bengen, an MIT aeronautics, and astronautics graduate turned Certified Financial Planner, made a historic discovery. Bengen, a number-cruncher by training, calculated actual stock returns and retirement scenarios over the last 75 years. What he found was that retirees who draw down 4% percent of their portfolio in their first year of retirement, and then adjust this amount every year for inflation, will very likely see their money outlive them, assuming a 50% to 75% allocation in stocks.

Based on his calculations, 80% of the time, nest eggs lasted 50 years. In the worst-case scenario, the money lasted 35 years.

Bengen’s 4% Rule brings clarity to the questions of how far we can dip into our nest eggs, how long we can make withdrawals, and what kind of allocation a well-constructed portfolio will have. It relieves the fearsome inflationary question, too.

This is how the 4% Rule came onto the financial planning world scene. When Bengen published his study, it immediately struck a chord with many private investors, who had seen years of high inflation that diminished their buying power. For these retirees and soon-to-be retirees, Bengen’s rule offered a glimmer of hope and provided a tangible and achievable savings target.

Here’s an illustration of the 4% Rule in action:

The Smiths have a cool $1 million stashed away for retirement. They decide to turn in their office keys in the same year. Under the 4% Rule, Mr. and Mrs. Smith can withdraw $40,000 (4% of $1,000,000) in their first year of retirement. During their second year, they can withdraw the same $40,000, except this time accounting for inflation. So, if inflation is at 5%, they’d take out $42,000 (the extra $2,000 being 5% of their $40,000 starting point). And so on for the next year and the next.

The 4% Rule does have its critics.

The Wall Street Journal (WSJ) published an article entitled, “Forget the 4% Rule: Rethinking Common Retirement Beliefs,” in which Wade Pfau, a professor at the American College of Financial Services in Bryn Mawr, Pennsylvania, argued that “3% is the new safe withdrawal rate.”

Pfau doubled down in a 2020 Forbes article, arguing that the 4% Rule really should be replaced with a 2.4% Rule. Note that Bengen’s new number of 4.5% is almost double that of Pfau’s!

If widely respected financial gurus are saying 2.4%, what’s stopping someone down the line from calling for 1% withdrawal as the new normal? I suppose they could, but who would listen to that advice?

The retirement marathon is already hard enough – it’s tough to stay the course for retirement savings, especially during market ups and downs. If you could only withdraw 1% or 2% of your savings, would you even start the race? Probably not. You’d just take on Suze Orman’s rule and work until you die, right? Because if you never take a dollar from your investments, you may never run out!

I’m so incredibly interested in this topic that I decided to gather a team and run the numbers to see where we landed. We recreated and updated the 4% Rule, which was originally released in 1994. I must admit to some trepidation about whether the rule would stand the test of time.

We replicated Bengen’s study, but with retirement withdrawals every year from 1929 to 2009, giving us 82 different retirement starting points. Using actual market data to 2017 (and updated to 2020 data recently), we made multiple simulations with historically conservative average return estimates after that: 5% for stocks, 2% for bonds, and 3% for inflation.

My team and I found that 70% of the time, the retirement funds lasted 50 years or more. In the worst-case scenario, the nest egg was depleted in 29 years. So, by my research, the 4% Rule still works. And an increase to a 4.5% Rule is just icing on your retirement cake.

Bengen has continued to run various iterations of the 4% Rule, and in Barron’s, he says that “by adding a third asset class, small-cap stocks, investors could safely withdraw as much as 4.5% annually.”  So large-cap stocks, bonds, and now small-cap stocks push the withdraw rate guideline to a juicy 4.5%.

Oh, and Bengen’s number is 88% higher than Pfau’s 2.4%! So, what’s the answer here?

The 4% Rule still works. This means that assuming 4% or higher inflation is still safe, but what remains most important is to have a dynamic withdrawal rate that hovers around 4%. Or, in the case of the new Rule, 4.5%.

Let’s walk through some examples:

Retirement begins on January 1st, 2000.

  • The S&P 500 kicks off your retirement with a brutal run of returns: -9%, -12% and -22% in the first three years.
  • After using actual stock, bond and CPI (inflation) numbers through 2017, we assume 5% stock returns, 1% bond and 3% inflation.
  • In this model, money lasts 46 years.

Retirement begins on January 1st, 2008.

  • Using actual returns through 2020, we thereafter assume 5% stock returns and 1% bond returns. In this model, we assume you don’t inflate your earnings every year. (Very possible if you follow the decline spend trend of the average American or don’t have significant housing expenses, by the way).
  • In this case, the money lasts 68 years!
  • If you spike to 3% inflation, spending goes from $40,000 to $135,000 in the last tested year. Quite extreme, but even then, money lasts 47 years!

Finally, let’s try January 1st, 2000 again, but this time with 5% withdrawal.

  • With actual returns and inflation, then 5%, 1% and 1% for stocks, bonds and inflation – money still lasts 35 years!

With our research, a few other helpful points to supplement Bengen’s study emerged.

The Buffett Zone*

If annual withdrawal rates ever dropped to a 2% level, portfolio growth would often turn exponential and we’d see the impact of a plummeting rate of withdrawal. Say a retiree had a $1 million portfolio and began using the 4% Rule to make $40,000 withdrawals in 1950. That turned into under 2% of portfolio holdings because of the outsized market returns of the 1950s and early 1960s. The retiree’s portfolio would have grown to $51 million in 2009 and over $100 million in 2020. The point is that $40,000 plus inflation is easily supported if there is a stretch of strong market performance.

*As in Warren Buffet. Buffett’s 2018 annual letter to investors showed a per-share market value gain for Berkshire stock of 2,404,748%. Yes, almost 2.5 million percent.

The Danger Zone

On the flip side, what if a portfolio endures a nasty market stretch and that same $40,000 plus inflation now represents a 6% withdrawal rate? This is when we see funds in danger of running out. For scenarios that began in 1965, portfolios were hit by poor market returns and historically high inflation. These factors spiked the withdrawal rate percentage and made it difficult to sustain. This was the root of the worst-case scenario discussed above of 29 years.

Despite all of the media skepticism, the 4% Rule still works. And, I believe the 4.5% Rule will pass the same muster.

In summation, I have three critical concepts for you to remember:

1. Retirement planning is not a straight line. There isn’t, and never will be, an exact percentage that retirees need nor want to stick to each year, come hell or high water. Remember that these “rules” are guidelines, not laws etched in stone. Flexibility is the key.

2. The real-world supports a 4.5% withdrawal rate. In my opinion, Bengen calculations are more accurate to follow than Pfau’s. That’s largely because Pfau’s numbers just aren’t practical – 3% and 2.4%. If 2.4% were the guideline, then the majority of Americans could never afford to retire.

3. Use 4% to 5% dynamically. From what I’ve seen during my 20 years of helping people plan for retirement, using a dynamic approach to your nest egg is the key. Anywhere from 4% to 5% is sustainable so long as you are willing to make adjustments as needed. And there’s always the three-step dance between the math (objective), common sense (subjective), and emotions (very subjective) like greed or fear.

So yes, drawing down less than 4% gives you, even more, cushion and protection. And 3%? Even better. What about 2%? Better still. How do plan to never run out of money? Never touch any of it and work until you die. But I’m guessing that most of us don’t want that kind of life. We want a happy retirement with financial stability to boot.

The takeaway is that retirement withdrawals aren’t static. Sometimes you can take out a little more, and sometimes you tighten the belt a little if you’ve over-spent or the markets aren’t particularly generous. Dipping into your nest egg should flexible, but it needn’t be miserly.

I am a believer in the 4% Rule and am excited about the new 4.5% Rule. After all, my focus is on happy retirees, and what makes a person happier in retirement than peace of mind, financial stability, and a nice raise? I’d say those are key ingredients to a retirement well-spent.

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