The 4% Rule: Why it still makes sense for retirement

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Saving for retirement
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The best rules are tried and true rules – guidelines that have served us well over time and circumstance. But even such gold standard rules should occasionally be re-examined and put back under the microscope to see how they are holding up in a changing world.

Considering the 4% Rule for a comfortable retirement

That’s what my team recently did with the 4% Rule, a long-established guideline for how much retirees can safely withdraw from their retirement accounts each year.  Our research project was prompted by a Wall Street Journal article that argued folks who live by the 4% Rule risk going broke.

Developed by William Bengen, a financial planner from MIT, the 4% Rule is based on a study that concluded retirees can safely take 4% of their initial retirement assets, and then increase that amount every year to account for inflation. For illustration, say you have $1 million saved. Applying the 4% Rule, you would withdraw $40,000 per year, every year during retirement while increasing the initial number up annually to match inflation. Bengen’s study assumed a portfolio consisting of 50% to 75% stocks.

In 1994, Bengen published his study in The Journal of Financial Planning. The findings indicated that, even under the worst possible scenario, a nest egg subject to the 4% Rule would last 35 years. In nearly 80% of the scenarios, however, the money would last 50+ years.

As you can imagine, the study hit home with American investors, especially among the generation that had seen years of double-digit inflation. The study allayed fears of buying power erosion, but it did much more: It offered everyday workers a glimmer of hope, and a tangible, achievable savings target. And so, for decades, the 4% Rule has been a much-loved, much-used principle of prudently living off of retirement savings.

Enter the recent WSJ article, entitled “Forget the 4% Rule: Rethinking Common Retirement Beliefs, “ which argued that, by following conventional rules of thumb, the average retiree is at risk of going broke, and that a withdrawal rate of 3% is a more realistic figure. But is this true?

Before I jump on any bandwagon, I look at the data and numbers behind the arguments.

In the case of the 4% Rule refute, I was especially curious to see the data. I wanted to know whether events like the bursting tech bubble of the early 2000s, the financial crisis of 2009 and/or amped-up Fed interest activity have made the 4% Rule obsolete and over-indulgent.

So, my colleagues and I recreated Bengen’s study with 25 years of updated market data.

Our goal was to determine whether or not the 4% Rule still works today. I went into the process understanding that our financial lives are not straight lines and that things can change. I also know that to be helpful, financial advice must be applicable in the real world. It also must be simple to understand, grounded in reality and backed up by (you guessed it) the numbers.

Helpful financial rules of thumb include my $1,000-a-month rule (which says you need $240,000 in assets for every $1,000 per month you want in retirement) and the 15/50 rule (which says if you have at least 15 years left before retirement, you should have at least 50% allocation of stocks). These guidelines are easy to follow and well-tested.  So is Bengen’s 4% Rule.

Our work recreated Bengen’s study with retirement withdrawals beginning every year from 1929 to 2009. This is 82 separate retirement starting points. We used actual market data until 2017 and ran multiple simulations with historically conservative average return estimates after that: 5% for stocks, 2% for bonds and 3% for inflation figures.

Here is a brief rundown of our findings:

  • 70% of the time (58 of 82 scenarios) retirement funds lasted 50 years or more.
  • 30% of the time, the money “ran out” – with the worst-case scenario in our study being 29 years.

Our conclusion: Yes, the 4% Rule still works.

Here are few sample outcomes from when we re-tested and stress-tested the 4%:

  • 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, the money lasts 41 years.
  • Retirement begins on January 1st, 2008.
    • Using actual returns through 2017, 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 77 years!
    • If you spike to 3% inflation, spending goes from $40,000 to $107,000 in the last tested year. Quite extreme, but even then, money lasts 39 years!
  • Finally, let’s try January 1st, 2000 again, but this time with 5% withdrawal.
    • With actual returns and inflation, then 5%, 1% and 0% for stocks, bonds and inflation – money still lasts 33 years!
    • With a constant $50,000 withdrawal, you get up to 65 years.

Our research surfaced a few other helpful points to supplement Bengen’s study.

The Buffett Zone (as in Warren Buffet) – Buffett’s 2018 annual letter to investors shows a per-share market value gain for Berkshire stock of 2,404,748%. Yep, that’s almost 2.5 million percent!

Here’s how the math works and how it applies to the 4% Rule.

If annual withdrawal rates ever dipped to 2%, portfolio growth often turned exponential, with withdrawal impact plummeting. Say, for example, a retiree had a $1 million portfolio and began $40,000 withdrawals in 1950. And say that then turned into under 2% of portfolio holdings because of the outsized market returns of the 1950s and early 1960s. That portfolio would have grown to $51 million in 2009 and over $100 million in 2017. The key here is that $40,000 plus inflation is very easy to support if there is a stretch of strong market performance.

Danger Zone Here’s the flipside: If a portfolio endures a particularly bad market stretch and that same $40,000 plus inflation now represents a 6% withdrawal rate, funds are in danger of running out. For scenarios that began in 1965, portfolios got hit with poor market returns and historically high inflation. These factors spiked the withdrawal rate percentage and made it difficult to sustain. This caused the worst-case scenario discussed above of 29 years.

Bottom line: Despite media cynicism, the 4% Rule still works, even more than two decades after Bengen published his work!

Yes, but what about [insert your 4% Rule financial fear here]?

Despite updated data, many will voice worries, particularly about inflation.

Here’s a mantra to calm your nerves: A constant inflation ratchet, while useful for model projections, is not a real-world reality, nor does it reflect buying reality.

Here again, the data are on our side. Average spending in America drops every decade past age 55 until age 75 when it bottoms out around $38,000. Americans’ peak spending is $71,000 annually, occurring in the decade between ages 45 – 54.

So, while inflation may be of genuine concern, it is rarely as pronounced as models lead us to believe. Even a 4% annual inflation bump turns your initial $40,000 into $130,000 forty years later, and that simply hasn’t been the reality of actual spending.

Ultimately, you are in control of what you spend. What too many financial pundits forget is that saving and spending are remarkably human experiences.

And remember, retirement planning isn’t linear – it’s a dynamic process. Just like your spending needs change over time, so too do your saving needs. As one example, say markets turn down a bit; most of us reign in our spending. Similarly, if we’re in a good bull run, we may sell something and take that dream vacation.

Ultimately, let these long-term studies be guides, but do allow yourself to be encouraged. Bengen’s model, even with mixing and matching return and inflation figures, along with some good common-sense budgeting, will get most folks far past the retirement finish line.

Disclosure: This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.

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Wes Moss About the author:
Wes Moss is the host of Money Matters – one of the country’s longest running live call-in, investment and personal finance radio show – on WSB radio. He is the Chief Investment Strategist at Capital Investment Advisors (CIA), and a partner at Wela, a digital financial advisory service. In 2017, Barron's named Wes ...Read more
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