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The 4% Withdrawal Rule May Be Dead

One of the hardest pieces of retirement planning is turning your savings into a steady stream of income. It can be a daunting task going from a paycheck each week to having to withdraw money from savings and a portfolio. To that end, financial planners and pundits have come up with a variety of ways to do just that.

One of the more famous and widely accepted withdrawal principals has been the 4% rule.

However, like many financial planning techniques, even the 4% rule may not work in the years ahead. Thanks to a variety of factors, the standard gauge for safe withdrawals doesn’t hold water. For investors and planners, this means rethinking future income needs and portfolio goals.

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4% Rule Basics

As we said, converting a portfolio to a steady flow of cash in retirement so you don’t run out of money is a tough nut to crack. That is, until financial planner William Bengen unveiled his landmark study back in 1994. Bengen looked at the 30-year rolling returns from 1926 onward for a 50/50 stock/bond portfolio. Looking at the returns, Bengen discovered that investors could have safely withdrawn an annual amount equal to 4% of their original assets—adjusted for inflation—each year. By doing this, investors wouldn’t have to worry about running out of money during their golden years.

The concept basically created a so-called spending floor for a portfolio and showed the test of time through terrible periods like the Great Depression and the Stagflation of the 1970s. Periods of better returns helped pad the periods of not-so-great ones, so 4% was a safe withdrawal rate for all scenarios.

With Bengen’s study in tow, financial planners quickly adopted the rule and it’s become the standard starting point for looking at withdrawals in retirement from a planning perspective.

Wrenches in the Machine

The problem is, the 4% rule may not work going forward. And that’s the basis of several new studies, including one from Morningstar.

The Great Recession reset the equation for the 4% Rule and its workings. During the Recession, various central banks around the world sunk interest rates to the basement floor to help jumpstart failing economies. Treasury bonds, on average, paid 3% to 4% during the 50/50 portfolios and the study’s lifetime. That wasn’t so during the Recession.

Then came the COVID-19 Crisis. Here again, interest rates plunged and threw the mechanics of the 4% rule out the window. In years when stocks were suffering, those high bond returns have helped steady the portfolio and have allowed investors to still withdraw needed funds. With rates at zero, that buoy simply isn’t there.

Going forward isn’t a piece of cake either. Thanks to the overvaluation of the market, expectations need to be lowered. According to FactSet, the S&P 500’s price/earnings ratio now sits at 23.88 when looking at reported earnings. That is much higher than the 17.35 average realized over the past 20 years. This is greater than the P/E used in the original 4% study. Charles Schwab estimates that investors will only be able to realize a 6.6% return from stocks going forward rather than the 10%+ during Bengen’s study.

Secondly, rates of inflation are now near 30-year highs. As such, interest rates will have to rise. This pushes down bond prices and creates a huge loss drag on half of a hypothetical portfolio in the 4% Rule study.

The final nail in the coffin? Longer lifespans of retirees. Thanks to modern medicine, the average person is now living longer than during Bengen’s original study.

The combination of the factors creates a less than ideal return expectation scenario for the next 30 years. And that’s what Morningstar has found. The firm ran simulated future returns over a 30-year period on a 50/50 stock/bond portfolio. Based on their analysis, about 25% of the time, investors would run out of money if they used a 4% withdrawal rule.

Morningstar now estimates that the 4% Rule and the new ‘safe’ rate of withdrawal should be lowered to 3.3% to start with. That’s a big haircut for many retirees. Those with a $1 million portfolio would lose $7,000 in income to start with under the new suggestions.

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There’s Hope

Now there is some hope for retirees and Morningstar does offer some suggestions. The study uses a 50/50 portfolio of stocks and bonds. That allocation is a dinosaur for most portfolios these days. According to Morningstar, a higher equity allocation provides greater success in not running out of money when using the 4% rate. The key is that stocks pay dividends and dividend growth has long averaged at rates above inflation. This provides the ability to still keep withdrawal rates higher.

Secondly, getting creative with the fixed-income side of the equation may be in order. There’s a whole world of bonds outside of treasuries. Investors may need to tap these fixed income securities for more of their fixed income needs. However, they do provide more volatility to a portfolio.

This is why investors may want to consider annuities for their needed expenses. Immediate and deferred annuities may be just what a retiree needs to keep the cash flowing during their golden years. It basically pushes the longevity and running out of money risk away from the investor.

In the end, the 4% Rule has been the standard for decades of retirees. However, going forward, this may not hold water anymore. For investors, rethinking withdrawal rates and changing our portfolios to achieve long-term success is now a must.

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Dec 22, 2021