Beyond the 4% Rule

Will your savings last as long as your retirement? It's a pressing question that keeps many Americans awake at night - and for good reason. The changing political, economic, and market environments can all impact retirement plans. A record number of people are also expected to retire this year, raising the question of how much they will need to have saved.

So, let’s address two of the most difficult questions everyone must face whether you are planning for or are already in retirement: how much is enough to ensure a secure and comfortable retirement, and how much can you safely withdraw per year without exhausting your savings?

Maximum withdrawal rates have varied over history

The answers, of course, are highly personal and depend on your goals. They are also sensitive to factors such as: the rate at which your portfolio grows, how your spending needs will change, and how long you need your money to last. Understanding these three variables is fundamental to financial planning, since they determine whether your savings will last throughout retirement.

First, when it comes to markets and the economy, we can't control the day-to-day market swings and whether investors begin retirement in a bull or bear market. However, history shows that markets have risen over time and can overcome short-term pullbacks. So, while it’s impossible to predict exactly how markets will behave in the coming years, we can minimize this risk by staying disciplined and having a portfolio allocation that is aligned with our goals.

Second, planning for retirement spending requires a thoughtful analysis of your anticipated lifestyle needs. Research shows that retirement spending often follows a “retirement smile” pattern - higher spending in the early years when retirees are more active, followed by a period of moderated spending in the middle years, before potentially increasing again due to healthcare expenses in later years. It is best to work through these estimates after taxes, which can play an important role in optimizing retirement distributions.

Finally, it’s important to understand how long you need your savings to last. The prospect of living longer than expected is often referred to as “longevity risk.” This risk can be difficult to manage because running out of funds is far worse for most households than leaving money behind to loved ones and charitable causes. This means that life expectancy is an important input to any financial plan, especially because today’s retirees are living longer than prior generations.

Retirement planning concepts to find your magic number

Once you have given serious thought to these three factors, you are in a position to calculate how much you need to retire, or your “magic number.” This is where many investors start with rules of thumb such as the “4% rule.”

In simple terms, the 4% rule attempts to answer the question "how much can I withdraw from my portfolio each year over the course of my retirement?" This concept was coined by William Bengen who observed that, historically, a 4% annual withdrawal rate from a portfolio was "safe" in that retirees were unlikely to exhaust their savings over a 30-year retirement horizon, accounting for inflation.

Of course, your experience will differ based on your goals, the market conditions you experience, and the length of your retirement. For this reason, the 4% rule is only a starting point for thinking about retirement, not the final answer.

While it might seem counterintuitive, many retirees don’t withdraw enough. The transition from disciplined saving habits to enjoying retirement spending is difficult for many people. History suggests that there is a basis for steady withdrawal rates of at least 4%. On average and with the benefit of hindsight, many retirees would have been able to withdraw 6.9% each year without running out of funds over the past century. These illustrative calculations show that only once in the 1960s did the maximum withdrawal rate fall as low as 4%.

The sequence of returns can dramatically impact the value of a retirement portfolio

The safe withdrawal rate can vary dramatically from year to year, a fact that should not be surprising given how much market returns can change across a cycle. One consideration is referred to as “sequence of returns risk,” or the idea that the timing of up and down markets can dramatically impact the value of a portfolio when making withdrawals in retirement. This is where being cautious can make sense, especially in today’s environment of high stock market valuations and elevated inflation.

So, how do we conduct retirement planning given these challenges? The 4% rule is based on oversimplified assumptions that do not account for differences in portfolios and risk tolerance across individuals that are a critical part of real-life financial planning. For instance, the 60/40 stock/bond portfolio it is based on may be quite aggressive for many retirees, especially later in life. Taxes and fees are also not built into the 4% rule analysis. This means it carries a lot of assumptions that might not reflect your personal situation. Instead, a highly personalized approach requires comprehensive financial planning, reflecting your investment strategy, risk tolerance, spending habits, taxes, and more.

Regardless of what a retiree’s withdrawal rate may be, it will be based on sticking to an appropriate investment plan throughout the full period. Investors who overreact to short-term market pullbacks would fail to rebound alongside the market, negatively impacting their withdrawal rates later in retirement. This is another reason why having proper guidance is important when planning for and managing a retirement that lasts decades.

The Bottom Line

The 4% rule is a helpful place to start but lacks the nuance that may be appropriate in determining the returns, withdrawal needs, and time for your specific situation. Understanding the various factors that affect retirement needs requires personalized financial guidance. When done well, this can increase the odds of enjoying a happy and financially healthy retirement.