Is the 4% rule no longer a viable strategy for withdrawing retirement savings?
That’s the question the Morningstar researchers asked when they reexamined this well-known rule of thumb. Developed in the 1990s, the 4% rule states that a retiree must withdraw 4% of their savings in their first year of retirement and adjust subsequent withdrawals for inflation each year. In doing so, the rule suggests, the retiree will have enough money to last 30 years.
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But Morningstar research suggests that this oft-cited rule of thumb needs updating. The financial services company found that retirees looking for a fixed withdrawal strategy that will produce 30 years of retirement income should start by withdrawing 3.3% of their savings.
Then again, the 4% rule assumes that retirees’ spending habits will remain static throughout their golden years, a premise that doesn’t always ring true. As a result, Morningstar has evaluated a series of alternative strategies that provide more flexibility to meet income needs that tend to fluctuate.
Rethinking the 4% rule
Developed in 1994 by financial planner William Bengen, the 4% rule has become a staple in retirement planning. Using historical data, Bengen demonstrated that a retiree whose portfolio is made up of half stocks and half of bonds can initially withdraw 4% of their retirement nest egg, then adjust future withdrawals based on inflation.
For example, a retiree with $ 1 million in savings would withdraw $ 40,000 in the first year of retirement. Since all subsequent withdrawals are adjusted for inflation, the same retiree would withdraw $ 41,200 in their second year of retirement if inflation was 3%.
However, Morningstar researchers say low bond yields and a likely overvalued stock market are the main reasons why a 4% withdrawal rate “may no longer be achievable.”
“Due to the confluence of low starting bond yields and high stock market valuations by historical standards, retirees are unlikely to receive returns on par with those in the past,” wrote Christine Benz, Jeffrey Ptak and Morningstar’s John Rekenthaler in their recent report. , “The State of Retirement Income: Safe Withdrawal Rates”.
Using an initial withdrawal rate of 3.3%, a retiree whose portfolio is split evenly between stocks and bonds has a 90% chance of maintaining a positive account balance after 30 years. The larger the portfolio’s equity position, the lower the initial withdrawal rate should be.
But Morningstar research shows that higher withdrawal rates don’t necessarily lead to cash-strapped retirees in their lifetimes. Most of the time, the 4% rule can still be successful in producing a positive account balance after 30 years. For example, a balanced portfolio of 50% stocks and 50% bonds passed 74% of the simulations Morningstar conducted using the 4% rule.
More flexible options
One of the main criticisms of the 4% rule is the assumption it makes regarding the spending habits of retirees. By adjusting annual withdrawals solely for inflation, a retiree has little leeway to spend more money year over year.
However, research shows that there is great variability in the spending habits of retirees. Using data gathered by the Survey of Consumer Spending, financial advisor Ty Bernicke noted that retirees generally spend less as they age. For example, retirees aged 75 and over spent less than those aged 65 to 74, while those aged 65 to 74 spent less than those aged 65 and under.
Again, older retirees face potentially greater medical expenses that will require greater spending on retirement savings.
While fixed withdrawal strategies produce stable and predictable cash flows, they come with inherent risks. “If the starting withdrawal is too low and the portfolio exceeds expectations, the retiree will leave a significant amount behind, which may not be a goal,” the Morningstar report says. “If the initial withdrawal is too high, the retiree will use too much too soon and risk exhausting prematurely and / or having to tighten their belts later in life.”
As a result, some retirees may forgo fixed withdrawal rate strategies like the 4% rule and instead opt for a withdrawal method that allows more flexibility from year to year.
Flexible strategies whose withdrawal rates change each year can ensure retirees don’t overspend during market downturns and provide more income in stronger economic environments. Morningstar researchers identified four alternatives to fixed withdrawal strategies such as the 4% rule, and assessed them based on several factors, including the median portfolio size after 30 years.
Here are these alternative withdrawal strategies:
Forgo inflation adjustments: This method is virtually identical to the 4% rule, but it ignores annual inflation adjustments after years in which a portfolio loses value. With a 50/50 split between stocks and bonds, a retiree using this approach could safely withdraw 3.76% of their savings in the first year and still have a 90% chance of having money after 30 years. .
“For retirees who are looking for a ‘paycheck-like’ approach that is likely to support a slightly higher starting and lifetime withdrawal percentage than a simple system of fixed real withdrawals, this simple strategy seems to work. a decent starting point, ”says the Morningstar report. “Also, there was much less variability in the retiree’s cash flow than with some of the other flexible strategies we tested.
Stick to the minimum distributions required: A Minimum Required Distribution (RMD) approach is simply dividing the amount of money in a portfolio by the retiree’s current life expectancy (as defined by the Internal Revenue Service) each year. This method produced the highest initial withdrawal rate (4.76%), as it assumes an average life expectancy of only 21 years after retirement.
“Using a single RMD life expectancy table to guide withdrawals, as we did in our test, could also cause some retirees to withdraw too much because it uses average life expectancies,” note the researchers. “Retirees who have a much longer than average life expectancy and / or younger spouses will want to be more conservative.”
Create safeguards for withdrawals: In addition to accounting for inflation, the “safety barrier method” sets limits on how much the withdrawal rate increases during times of market strength and how much during economic downturns. With a portfolio of 50% stocks and 50% bonds, a retiree could start by withdrawing 4.72% of their savings, then set parameters to determine how far the rate can go, depending on the performance of the wallet. Morningstar found that this method “does the best job of increasing payouts in a safe and sustainable manner.”
Reduce the withdrawal rate by 10% after losses: Similar to the first alternative strategy, this method relies on reacting to losing years. retirees using this strategy would reduce their withdrawal rate by 10% after years of the portfolio losing value. This approach produced an initial withdrawal rate of 3.57%, slightly higher than the 3.3% suggested for a fixed rate strategy. However, this approach also resulted in the portfolios’ highest median closing value after 30 years, making it the best option for retirees motivated by the idea of leaving a bequest to family and friends. .
Morningstar research shows that the well-known 4% rule needs updating, although it is not completely obsolete. Instead, the financial services company says retirees who hope to use a similar fixed rate withdrawal strategy should use 3.3% as a starting point and then adjust accordingly. There are several alternative strategies that allow a retiree to adjust their sources of income and meet spending needs that may change, including health care expenses. The guardrail method may be the most suitable alternative, according to Morningstar.
Tips for planning for retirement
Pay attention to the costs associated with your investments. The expense ratio of a mutual fund or a publicly traded fund can dramatically reduce your returns over a long period of time. Be sure to check the expense ratio of any fund you own or hope to invest in. Finding a cheaper alternative can save you a lot in the long run.
A financial advisor can help you determine your retirement income needs and create a plan to meet them. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is best for you. If you’re ready to find an advisor, start now.
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The article New Research Shows Why You Should Rethink This Popular Retirement Strategy first appeared on the SmartAsset blog.