Rules of thumb – society has many of them. Don’t swim right after eating. Get eight hours of sleep. In the world of personal finance, it’s things like: Pay yourself first, build an emergency fund and plan for retirement.
When it comes to retirement planning, you’ve probably heard of the 4% rule. As a quick refresher, this is a withdrawal strategy where you take out 4% of your portfolio in the first year of retirement. Then in the years after, you’d simply adjust the withdrawal amount for inflation.
Here’s a basic example how the 4% rule works: Let’s say you retire with $1 million in your portfolio. Under the rule, you would withdraw $40,000 (4% x $1,000,000) in the first year of retirement.
In the second year, you’d withdraw $41,200. This amount includes an adjustment for inflation. So if inflation is at 3%, you’d take out an extra $1,200 (3% of $40,000). You’d continue to do this for the following years.
The thinking goes that if you stick with this formula, your retirement savings should last you at least 30 years. In other words, the chances of you running out of money before the end of retirement (assuming a 30-year period) are low.
The 4% rule, like any other rule of thumb, is not set in stone. It’s a general strategy for managing retirement withdrawals. It may not work for everyone or every retirement scenario. After all, there are many personal variables to take into consideration when it comes to choosing an appropriate withdrawal strategy for you. For example, return rates may vary or your spending rate could change.
With that in mind, let’s take a look at whether the 4% rule still makes sense in today’s environment.
A closer look at the 4% rule
Figuring out a reasonable retirement withdrawal rate is a balancing act. Take out too much and you run the risk of outliving your retirement. But if you take out too little, you may not be able to have the retirement that you want.
Is there a “safe” withdrawal rate that retirees can look to as a guidepost – one that could help minimize the risk of running out of money in retirement?
William Bengen, a financial advisor, attempted to answer that question in his 1994 seminal study on withdrawal rates.
After testing a series of hypothetical retirement scenarios with different market conditions, Bengen concluded that a retiree could safely withdraw as much as 4% – or 4.15% to be more precise – from their retirement portfolios each year (with adjustments for inflation after the first year) and could still have money left over after 30 years.
Note: Bengen’s 4% rule assumes a balanced portfolio – 50% US large cap stocks and 50% intermediate-term Treasury notes.
In Bengen’s study, the 4% rule holds regardless of whether a retiree faces a favorable or unfavorable sequence of returns. In fact, under a favorable sequence, you could, in some cases, have substantial funds left over at the end of retirement. Before we take a look at an example, let’s take a step back. What is sequence-of-returns risk?
This is the risk where negative portfolio returns early in retirement could impact the longevity of your retirement funds. For instance, if the market is going through a downturn just as you’re starting to withdraw from your portfolio, the combination of negative returns and your drawdowns could deplete your nest egg sooner than expected. Sequence risk is a potential risk for everyone because nobody can predict what the market will do as you enter retirement.
The 4% rule is commonly seen as a way to manage this risk and help retirees avoid running out of money early. Remember, Bengen arrived at the 4% rule after testing a wide variety of hypothetical scenarios. And he found that even under an unfavorable sequencing scenario, a retirement portfolio that follows the 4% rule should last at least 30 years.
But what if there was a favorable sequence of returns? This is where it gets interesting. Michael Kitces, an oft-cited certified financial planner, found that:
“[A] retiree who starts out with $1 million in a portfolio at a 4% initial withdrawal rate is equally likely to finish with less than $1 million, or more than $6 million, after 30 years! And just as the portfolio winds down to $0 in the one worst scenario…it also finishes at more than $9 million in the one best historical scenario!” (For more details on his analysis, see: “The Extraordinary Upside Potential of Sequence of Return Risk in Retirement”)
To be sure, having any amount of money left over at the end of retirement can be counted as a financial “win.” But what if you’re the retiree in Kitces’ example with $6 million left in your portfolio at the end of retirement? In some ways, having too much money left over in the end is its own kind of risk because it means you could’ve spent more money in retirement (which may leave you to wonder what kind of life experiences you’ve left on the table).
Updating the 4% rule
Kitces’ analysis brings us back to our original question: Does the 4% rule still make sense for retirees today?
Some advisors believe the 4% rate could be increased to 4.5% based on Bengen’s updated research on the topic. In his update, Bengen noted that retirees could safely withdraw as much as 4.5% by adding a third asset class – small cap stocks – to their balanced portfolio. (Curious about small caps? Talk to your financial advisor who can help you understand their pros and cons for your portfolio.)
As is the case with any financial plan, it’s important to remember that rules of thumb are just general guidelines. No rule (whether it’s 4% or 4.5%) will fit every retiree’s needs perfectly. (In fact, the 4% rule isn’t without its critics. Some believe it’s too high or too inflexible.)
Your withdrawal strategy will depend on a number of factors, which can include family dynamics, goals and sources of income outside of your investments. The appropriate withdrawal rate for you could be higher or lower than 4% depending on your circumstances.
That’s why it’s important to work with an experienced financial advisor who can provide ongoing planning support and help ensure you have the income and liquidity you need during retirement.
If you’re ready to take the next step in your financial journey, check in with your financial advisor who can work with you to assess your retirement readiness and determine an appropriate withdrawal rate for your specific situation.
United Capital Financial Advisers, LLC d/b/a Goldman Sachs Personal Financial Management (“GS PFM”) is a registered investment adviser and an affiliate of Goldman Sachs & Co. LLC (“GS&Co.”) and subsidiary of The Goldman Sachs Group, Inc., a worldwide, full-service investment banking, broker-dealer, asset management, and financial services organization. Advisory services are offered through United Capital Financial Advisers, LLC and brokerage services are offered through GS& Co., member FINRA/SIPC.
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United Capital Financial Advisers, LLC d/b/a Goldman Sachs Personal Financial Management (“GS PFM”) is a registered investment adviser and an affiliate of Goldman Sachs & Co. LLC and subsidiary of The Goldman Sachs Group, Inc., a worldwide, full-service investment banking, broker-dealer, asset management, and financial services organization.
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