Should I use The “4% Rule”
The 4% rule was first popularized in the 1990s by William Bengen, a financial advisor and researcher. Bengen developed the rule based on historical data and simulations that evaluated various withdrawal rates from a retirement portfolio of 50% stocks and 50% bonds.
The rule was created using historical data on stock and bond returns over the 50-year period from 1926 to 1976. He concluded that a withdrawal rate of 4% in the first year of retirement, adjusted for inflation (either up or down) in subsequent years, had an extremely high probability of being sustainable for at least 30 years.
The 4% rule assumes a fairly conservative investment portfolio, a long retirement horizon (30 years), and a withdrawal rate that is intended to be adjusted for inflation. It also assumes your retirement lifestyle doesn't change significantly over time.
There are some major flaws with using this approach to your own Retirement Income Strategy however:
Retirees spending typically doesn’t keep up with inflation
Most retirees have a few distinct phases in their retirement as follows:
The “Go-Go” Years: Lots of vacations, discretionary spending, fun!
The “Slow-Go” Years: Much less travel and dining out. Much more time spent close to home.
The “No-Go” Years: Typically homebound or limited trips outside of the home. Healthcare costs can go up substantially.
There’s a name for this type of spending pattern that these phases create. It’s called The Retirement Spending Smile.
The Retirement Spending Smile is a graphical representation of the idea that an individual's spending during retirement may not be constant over time. The pattern creates a "smile".
According to the retirement spending smile, spending in the early years of retirement may be higher as individuals have more energy and engage in more activities, then level off as they enter their mid-70s and beyond. In the later years of retirement, spending may decline as health expenses increase and the individual's lifestyle becomes more sedentary.
The retirement spending smile is a useful concept for individuals planning their retirement, as it helps to account for the changing needs and expenses they may face over time. By considering these changes and adjusting their spending accordingly, retirees can ensure that their savings will last throughout their retirement years. It's important to keep in mind that individual circumstances, such as health, lifestyle, and inflation, can affect spending patterns and that each person's experience may be different.
The 4% rule would ultimately produce a considerably higher rate of withdrawal if one assumes for a typical Retirement Spending Smile.
Acknowledging and being willing for your expenses to go down in your No-Go years allows for a much more lenient initial withdrawal rate.
Most Retirees are willing to adjust
The 4% rule also assumes you never adjust your spending even in catastrophic market conditions.
Being even a little flexible and willing to reduce withdrawals if extreme markets occur will also allow for a much higher initial withdrawal rate and greater spending throughout your retirement.
The 4% Rule also leaves a lot of lifestyle spending on the table because it doesn’t allow for increases in withdrawals if your portfolio has done well.
Adopting a “Guardrail” approach is a much more reasonable approach.
The guardrails approach to retirement income is a method of planning and managing retirement spending that aims to provide a stable and sustainable source of income while also allowing for some flexibility. The approach uses "guardrails," or boundaries, to guide spending decisions and help retirees avoid running out of money.
A guardrails approach might involve setting up a minimum and maximum withdrawal rate based on a retiree's portfolio and expected returns. For example, a retiree might choose to withdraw no less than 4% and no more than 6% of their savings in a given year. The approach also involves regularly monitoring the retiree's portfolio and adjusting the withdrawal rate as needed to ensure that the portfolio remains within the established guardrails.
The guardrails approach can provide a sense of security and stability for retirees, as it helps to ensure that their spending remains within a sustainable range. At the same time, the approach allows for some flexibility, as retirees can adjust their spending based on their changing needs and circumstances.
Risk Tolerance isn’t one size fits all
The 4% Rule assumes that retirees are willing to ride the highs and lows of the Market.
Not everyone can stomach such fluctuations in their nest egg during retirement and a more conservative approach may best suit them such as guaranteed income from an annuity or a portfolio more heavily invested in bonds.
The 4% Rule isn’t a great Retirement Income Approach.
It’s an extremely conservative and inflexible rule that has gained a lot of media attention for it’s simplicity to understand.
It’s main purpose is a good measure of the income a 50/50 portfolio has been able to historically produced in the worst of circumstances.
As always, consulting with a Retirement Planner can help individuals determine the right approach for their retirement planning needs.
