Limitations and Adjustment Methods of the “4% Retirement Spending Rule”

For decades, the “4 Percent Rule” has been a guideline for retirement spending. According to David Blanchett, Managing Director and Head of Retirement Research at PGIM DC Solutions, 61% of financial advisors use the 4% withdrawal rule.

This rule suggests that retirees should annually withdraw 4% from their savings, adjusted for inflation, to ensure that they do not deplete their retirement funds over a 30-year period. Developed in the 1990s, this concept has saved many retirees from financial struggles. However, with changing economic conditions, many experts have begun to question its effectiveness.

Let’s take a step back for a moment. William Bengen analyzed historical market data on stock and bond returns from 1926 to 1976 and concluded that a 4% withdrawal rate was safe. He assumed a balanced allocation between stocks and bonds under different market conditions. Even during challenging economic times like the Great Depression, the 4% rate was considered “safe.”

But let’s face reality: times have changed. The 4% rule may be starting to show its age.

– **Low Bond Yields**: In Bengen’s era, bonds were a stable foundation in the investment world, offering decent returns to cushion the impact of stock market downturns. However, with interest rates currently at historic lows, bond yields may not support a lavish lifestyle.

– **Stock Market Volatility**: Stock market fluctuations have become the new normal, enough to make one dizzy. When you’re withdrawing funds and the market dips (especially early in retirement), losses can be pronounced and distressing. This is known as “sequence of returns risk” in finance, which could jeopardize your retirement.

– **Increased Lifespan with a Cost**: Medical advancements have extended our lifespans like never before. However, this also means that our retirement savings must last longer. The 30-year time period assumed by Bengen? It might be overly optimistic for some of us.

– **Soaring Healthcare Costs**: In recent years, medical expenses have skyrocketed. This wasn’t a significant factor at the beginning of implementing the 4% rule. Even the most carefully planned retirement could veer off track due to this.

Considering all these factors, the 4% rule is starting to look less like a “rule” and more like a guideline, a starting point for deep discussions on retirement planning.

So what can retirees do? Fortunately, there are many alternatives to the 4% rule that offer more flexibility, customization, and peace of mind.

Imagine a retirement plan that adjusts based on market volatility. That’s the beauty of dynamic withdrawal strategies.

– **Portfolio Percentage**: Withdraw a percentage of your portfolio annually rather than a fixed amount. This percentage may fluctuate between 3% to 5%, allowing your spending to adjust with investment performance. You can splurge a bit more when the market is up and tighten your belt when it’s down.

– **Guardrails**: Think of it as setting spending boundaries. You establish upper and lower limits. If your portfolio performs well, you can increase withdrawals (within the upper limit). During market downturns, you reduce withdrawals to stay within the lower limit. It provides a safety net while allowing some flexibility.

To successfully implement this dynamic strategy, you need some self-discipline and regular check-ins. However, they offer more resilience compared to rigid rules like the 4% rule.

Have you heard of the bucketing strategy? It involves organizing your retirement savings into different buckets.

– **Short-Term Savings Bucket**: This is your emergency fund comprising cash or cash equivalents enough to cover 1-3 years of living expenses. This way, you don’t need to sell investments during market downturns.

– **Medium-Term Savings Bucket**: This bucket holds expenses for 3-10 years. These funds can be more aggressively invested in bonds or other investments with moderate growth potential.

– **Long-Term Savings Bucket**: Stocks in this bucket are meant to outpace inflation over time.

This strategy caters to both your long-term investment growth and immediate needs. While your long-term investments recover, the safety of your securely stored buckets helps mitigate the risk of market crashes, especially in the early years of retirement.

Bogleheads, an investment community known for personalized investing, advocates for this model:

– **Age, Asset Allocation, and Balance**: The VPW strategy considers your age, asset allocation (stocks or bonds), and current investment portfolio balance to determine the appropriate withdrawal rate.

– **Chart-Based Approach**: Retirees can refer to charts created for the VPW strategy to make withdrawal decisions.

Overall, this strategy aims to adapt to market returns, reducing the possibility of depleting your savings. However, you may find your spending fluctuating with the market, which can be unsettling.

This rule is inspired by the Yale Endowment Foundation, balancing the need for stable income with maintaining fund value.

Dual-Track Hybrid Model:

– 70% of the previous year’s allocation, adjusted for inflation. This provides stable income adjusted for inflation.
– 30% of the average fund balance over the past three years, multiplied by a fixed 5% spending rate. This allows adjustment of spending based on market performance.

With the 70/30 split, you can adjust according to your risk tolerance and expected income stability level.

Through the dividend withdrawal rule, retirees can preserve principal assets for inheritance while leaving a legacy.

Developed by James Garland, former President of The Jeffrey Company, this strategy found that withdrawing 130% of investment dividends can sustain income while preserving inflation-adjusted principal growth.

By linking spending to dividends instead of portfolio value, this strategy reduces volatility. Additionally, by limiting withdrawal amounts, the principal can grow or remain stable, making it an ideal choice for those concerned about leaving a legacy.

You can start receiving benefits at 62. However, opting to start later, say at 70, can be beneficial. While beginning benefits early may seem reasonable, delaying can increase your monthly payments later on. For every year you delay post full retirement age, your benefits increase by 8%.

In essence, if you anticipate a longer lifespan or aim to maximize your secure income, delaying benefits is a reasonable choice.

Annuities offer reliability and mitigate two major retirement risks:

– **Longevity Risk**: Not having enough savings due to extended lifespan.
– **Sequence of Returns Risk**: Early market downturns in retirement that could deplete your investment portfolio.

Modern annuities have lower costs and commission-free options, making them more consumer-friendly. Besides providing peace of mind, they come with trade-offs such as decreased liquidity and fees. Retirees considering annuities should carefully evaluate their goals.

As per the 4% rule, stocks and bonds should be evenly allocated. However, increasing the stock allocation to 75% can enhance portfolio durability and growth, especially as life expectancy increases. While stocks have higher volatility, they may offer better long-term returns.

The Internal Revenue Service (IRS) mandates retirees to take Required Minimum Distributions (RMDs) from Tax-Deferred accounts once they turn 72. Unlike the 4% rule, RMDs are calculated based on account balance and life expectancy each year. For some retirees, taking RMDs might be a more practical option. If you don’t need this income, you can reinvest RMDs to continue growing your wealth.

While the 4% rule is a good starting point, it’s not a one-size-fits-all solution. Considering your unique circumstances and exploring these alternative strategies can help you create a retirement plan that ensures income and security.

Remember, retirement planning is an ongoing process. Regularly review your plan and make adjustments as needed to ensure you meet your financial goals.