The 4% Rule Faces New Problems Today

There’s something every retirement saver should know: The often cited “4% retirement income rule” is not actually a “rule.”

Despite what some people think, this retirement planning concept does not guarantee that “as long as you take out only 4% of your retirement savings each year, your retirement nest egg will be safe.” More accurately, this concept is only a rule of thumb that can help you gauge a target drawdown your retirement savings might generate. I sometimes hear, “It’s not like I need to be a millionaire – I just need about $40,000 a year from my savings!” The 4% rule says that you then need at least $1 million in retirement savings – 4% of $1 million is $40,000.

The 4% rule essentially hypothesizes that, based on past U.S. investment returns, a retiree expecting to live 30 years in retirement should be safe (in other words will have money left over at death), if she withdraws approximately 4% of her retirement capital each year, adjusting the income annually for inflation. This idea further assumes your retirement savings is invested in a 60/40 mix of equities and fixed income products.

The idea isn’t to guarantee that this percentage will be sufficient, nor does the concept suggest if you take more than 4% you will be bankrupt at death. It just tells you there’s a high likelihood, based on past market performance, that you’ll have enough for retirement. 

Where the 4% Rule Goes Wrong

The 4% rule may be a problem particularly for people contemplating a retirement in the near future. In the past, the concern has been that a 4% drawdown may be too conservative, and in many market scenarios the retiree will end up taking far too little as a retirement income. Essentially, they may be too stingy with their savings to really enjoy their retirement. And yes, that’s still possible.

The flip side of this idea, however, is more the present-day concern: 4% may be an unrealistically high amount to withdraw.

Here’s the problem. This concept is based on averages, and retirees can’t spend averages. Right now we have an investment market that is alarming from two perspectives: Stock prices are sitting at historically high levels, while bonds are paying out historically low incomes. The fear is that if equities experience a market correction, and your retirement capital takes a plunge, this plunge will be difficult to recover from, because your savings is being drawn down each year – you’re decumulating your portfolio. And the bond part of your portfolio may not be of much help, because rates are so low. If you’re only generating 3% coupons on your bonds, how can you withdraw 4% each year and expect bonds to shore up your capital?

Rising inflation just makes it worse. As interest rates go up, the value of your current bonds goes down. 

Another trouble with the 4% rule is that it is based on U.S. investment experience during the 20th century. As the 21st century sweeps us into a globalized investment market, is it realistic to assume markets will continue their inevitable march upward? Will down-markets always be short lived and recoveries always quick?

Since no one who retired near the end of the last century has lived the requisite 30 years yet, we don’t know how well the 4% rule will stand up for them. If they retired at the peak of the tech bubble, even with the positive returns of the last decade, they may be dealing with significantly reduced retirement portfolios. And a “lost decade” going forward could exhaust what little of their savings is left.    

A Smarter Way to Use the 4% Rule

Does this mean you should abandon using the 4% rule? No, as long as you understand it’s just a litmus test, a gauge, a starting point. And you should further figure the rule is likely not as conservative a measure as it used to be. We may not see the rosy conditions that drove the U.S. stock market in the second half of the 20th century.

A way to utilize the rule is to add up your expected savings at retirement and see if 4% of that number will generate your target retirement income. If not, it’s time to go back to the drawing board and figure out how to boost your retirement savings.

 If 4% does give you an adequate retirement income, roll up your sleeves and start looking at your particular plan. Ask yourself:

• Will you be like many retirees, and spend bigger during your “go-go” years in early retirement and less during your “no-go” years later on?
• Do you have the stomach for a portfolio that emphasizes stocks over fixed income?
• And importantly, are there ways you can turn some of your retirement capital into guaranteed retirement income – taking the pressure off the annual drawdown from your portfolio? Annuities, bond ladders, and even government inflation bonds are all possibilities.

As you can see, the 4% rule can get things started, but it’s not the end solution.