After two decades of financial media bashing, is it time to revive common retirement beliefs?
Recently, the Wall Street Journal caused a stir with an article titled, Forget the 4% Rule: Rethinking Common Retirement Beliefs. From the title, the author’s premise is clear – rethinking tradition is long overdue and, by following conventional rules-of-thumb, the average retiree is at risk of going broke.
Is he right? Well, let’s look at the rule in question.
Developed by William Bengen, a financial planner from MIT, the 4% Rule study offers this: a retiree can take 4% of their initial retirement assets, and increase that amount every year to account for inflation, assuming a 50% to 75% portfolio allocation to stocks.
Bengen published this study in 1994 – with data up through 1992 – in the renowned Journal of Financial Planning. The study’s worst-case scenario was that money lasted 35 years. Of course, the results immediately struck a mainstream chord. For a generation that had seen years of double-digit inflation and feared the buying power erosion in these periods, the study offered a glimmer of hope and provided a tangible and achievable savings target.
Now, the WSJ article author says 3% is a better withdrawal rate.
Suze Orman says work until you’re 70, just to be safe.
What’s next, financial gurus calling for 1% withdrawal as the new normal?
Instead of being resigned to meager withdrawals and impossibly high expectations of stockpiled cash, I decided to re-create Bengen’s study with 25 years of updated market data.
Is the WSJ right, and do events like the bursting tech bubble of the early 2000s, the financial crisis of 2009 and revved up Fed interest activity make the 4% Rule irrelevant and over-indulgent?
Does the 4% Rule Work Today?
At some point, financial advice has to be applicable in the real world. People’s lives are not static financial models. Any advice – if it’s to be helpful – needs to be simple to understand, grounded in reality and backed by data. Helpful ‘rules of thumb’, like the $1,000-a-month rule (which says you need $240,000 in assets for every $1,000 per month you want in retirement) and the 15/50 rule (which says if you have at least 15 years left before retirement, you should have at least 50% allocation of stocks), have staying power because they are easy to follow and well-tested. Bengen’s rule is just like that.
Here’s an example of the 4% Rule in action:
Jane starts with $1 million in her retirement account on Day 1, in Year 1 of retirement. She takes 4%, or $40,000, out for living.
Inflation goes to 5%, so in Year 2, Jane takes the same $40,000 (which was 4% of her initial portfolio balance) plus 5% to account for inflation that year. Her withdraw in Year 2 is $42,000.
In Year 3, inflation soars to 10%. So she takes her Year 2 amount ($42,000) and adds another 10% to account for this inflation.
Each year she works with her financial advisor to rebalance her portfolio back to the original 50% allocation to stocks.
Jane’s worst case scenario is enough cash for 35 years.
Further, Bengen’s study showed that in nearly 80% of the time periods tested, money would last 50+ years.
So, what about today?
Our work recreated the study with retirement withdrawals beginning every year from 1929 to 2009. This is 82 separate retirement starting points. We used actual market data until 2017 and ran multiple simulations with historically conservative average return estimates thereafter: 5% for stocks, 2% for bonds and 3% for inflation figures.
Before we move on, here’s a spoiler:
- 70% of the time (58 of 82 scenarios) retirement funds lasted 50 years or more.
- 30% of the time, the money “ran out” – with the worst-case scenario in our study being 29 years.
Bengen’s rule brings clarity to the question of what we can take out from our nest eggs, for how long and what kind of allocation a well-constructed portfolio will have. It relieves the fearsome inflationary question too.
And, yes, the rule still works.
Here are few sample outcomes from when we re-tested the 4% Rule:
- Retirement begins on January 1st, 2000.
- The S&P 500 kicks off your retirement with a brutal run of returns: -9%, -12% and -22% in the first three years.
- After using actual stock, bond and CPI (inflation) numbers through 2017, we assume 5% stock returns, 1% bond and 3% inflation.
- In this model, money lasts 41 years
- Retirement begins on January 1st, 2008.
- Using actual returns through 2017, we thereafter assume 5% stock returns and 1% bond returns. In this model, we assume you don’t inflate your earnings every year. (Very possible, if you follow the decline spend trend of the average American or don’t have significant housing expenses, by the way).
- In this case, the money lasts 77 years!
- If you spike to 3% inflation, spending goes from $40,000 to $107,000 in the last tested year. Quite extreme, but even then, money lasts 39 years!
- Finally, let’s try January 1st, 2000 again, but this time with 5% withdrawal.
- With actual returns and inflation, then 5%, 1% and 0% for stocks, bonds and inflation – money still lasts 33 years! With a constant $50,000 withdrawal, you get up to 65 years.
As well, our research surfaced a few other helpful points to supplement Bengen’s study.
The Buffett Zone*
If annual withdrawal rates ever dropped to a 2% level, portfolio growth often turned exponential, with withdrawal impact plummeting. For example, if a retiree had a $1 million portfolio and began $40,000 withdrawals in 1950, and that turned into under 2% of portfolio holdings because of the outsized market returns of the 1950s and early 1960s, that portfolio would have grown to $51 million in 2009 and over $100 million in 2017. The key being that $40,000 plus inflation is very easy to support if there is a stretch of strong market performance.
*As in Warren Buffet. Buffett’s 2018 annual letter to investors shows a per-share market value gain for Berkshire stock of 2,404,748%. Yes, that’s almost 2.5 million percent.
On the contrary, if a portfolio endures a particularly bad market stretch and that same $40,000 plus inflation now represents a 6% withdrawal rate, this is where funds are in danger of running out. For scenarios that began in 1965, portfolios were hit by poor market returns and historically high inflation. These factors spiked the withdrawal rate percentage and make it difficult to sustain. This caused the worst-case scenario discussed above of 29 years.
Despite media cynicism, the 4% Rule still works, even over two decades after Bengen published his work.
Yes, but what about [fill in the blank on a financial fear]?
Despite updated data, many will voice worries, particularly about inflation.
But a constant inflation ratchet, while useful for model projections, is not a real-world reality. Nor, does it reflect buying reality.
Here again, data is one our side.
Average spending in America drops every decade past age 55. Americans’ peak spending is $66,000 annually, occurring in the decade between ages 45 – 54. It drops on a decade by decade average basis until age 75, bottoming out at $37,000.
So, yes, while inflation may be of concern, it rarely is as pronounced as models lead us to believe. Even a 4% annual inflation bump takes that initial $40,000 and turns it into $130,000 forty years later. That type of up-leveled spending simply hasn’t been the reality.
Ultimately you are in control of what you spend. What too many financial pundits forget is that saving and spending is a remarkably human experience. Our retirement plan isn’t a robotic, set-it-and-forget-it process. Whether you are 30, or 50 or 80, you flex your spending and saving depending on your needs and the performance of your income or portfolio. Markets turning down a bit? Reign in the spending. Benefiting from a good bull run? Sell something and take that vacation.
The bottom line is that long-term studies are guides, but today’s investors should be encouraged. Bengen’s model – even while mixing and matching return and inflation assumptions – plus some common sense budgeting, gets most people over the finish line.