A few recent articles have somberly pronounced that the so-called “four percent rule” is dead, a victim of low interest rates, stock market volatility, high stock valuations, and longer lifespans. For those of you unfamiliar with the term, this phrase refers to a simple rule of thumb that determines the annual “safe” rate at which people should withdraw money from their savings during retirement.
It turns out that whether a withdrawal rate of 4% is considered to be safe depends on whether you’re using a strict application of the four percent rule or a more modern, “dynamic” savings withdrawal strategy.
To see my reasons for this conclusion, let’s take a closer look at each of these two savings withdrawal strategies.
A strict application of the four percent rule might not be “safe”
The original four percent rule was based on seminal research first published by Bill Bengen in 1994. Under this version of the rule, you calculate 4% of your retirement savings at the time you retire, and that’s the amount you withdraw during your first year of retirement. Each year thereafter, you increase your annual withdrawal amount to reflect the increase in the cost of living, regardless of how your investments have performed during retirement.
Bengen’s analyses (and those of many subsequent analysts) then estimated the likelihood that this withdrawal strategy would fail over a 30-year retirement. These analyses looked at various allocations between stocks and bonds, and often assumed allocations between 50% and 75% to stocks. “Failure” was determined to be a scenario in which assets were exhausted before 30 years had elapsed. An “acceptable” failure rate was quite low: 10% or lower.
Locking in a withdrawal strategy at retirement without taking into account subsequent investment performance creates a few problems:
- If your investment performance during retirement is favorable but you don’t change your withdrawal amounts, then you’d forgo the opportunity to increase your retirement income. You could do so without increasing the risk that your assets could be exhausted during retirement.
- On the other hand, if your investment returns are poor, particularly early in retirement, the risk of eventual failure increases if you continue withdrawing the same amount from your savings and continue increasing future withdrawals for inflation.
It’s important to point out that Bengen prepared his original analyses at a time of much higher interest rates on bonds and lower stock market valuations, which is one valid criticism of the original four percent rule in today’s environment. And indeed, in a recent blog post by Wade Pfau, a widely respected retirement researcher, he estimated that if you use the original methodology in today’s interest environment, the 4% withdrawal rate should really be 2.4%.
Another legitimate concern about a strict application of the four percent rule is that retirement can last longer than 30 years, especially given today’s life expectancies among retirees who have enough wealth to be concerned about safe withdrawal strategies.
Fortunately for retirees, the shortcomings described above can be addressed by using a more dynamic savings withdrawal strategy.
The dynamic savings withdrawal strategy
You can still use 4% as a withdrawal rate, provided you use a dynamic withdrawal strategy. With such a strategy, to determine the amount of your annual withdrawal, you apply 4% to the value of your assets that remain at the beginning of each calendar year (or periodically if you decide to adjust your withdrawals more frequently or at other times of the year).
With the dynamic withdrawal strategy, you can increase your withdrawal amounts if you realize favorable investment returns, but you should also decrease your withdrawal amounts if your returns have been unfavorable. The automatic readjustment of the annual withdrawal amount also addresses the concern you might have if your retirement lasts longer than 30 years. With a dynamic withdrawal strategy, you’ll never fully deplete your assets, since you’ll readjust your withdrawal amount every year by applying a small percentage to your remaining assets.
Pfau’s post cited above shares research that supports using a 4% withdrawal rate together with a dynamic withdrawal method.
It’s important to understand that the annual withdrawal amount in a dynamic withdrawal strategy will fluctuate from year to year, depending on your allocation to stocks and investment returns. You can mitigate the potential disruption in your lifestyle of this fluctuation if you build a floor of guaranteed income by optimizing Social Security; if you need more guaranteed income, you can use a portion of your savings to purchase a cost-effective payout annuity.
Here’s one more note: Research that Pfau, Joe Tomlinson, and I conducted with the Stanford Center on Longevity and the Society Actuaries examined other dynamic withdrawal strategies you could use that wouldn’t result in asset exhaustion. Examples include an annual withdrawal rate of 5% or the IRS required minimum distribution (RMD), which increases the withdrawal rate depending on your age. For example, the IRS RMD withdrawal percentage is 3.65% at age 70, 5.35% at age 80, and 8.77% at age 90.
There are many viable strategies for generating income from your retirement savings. It’s well worth your time to determine the strategy that will work best for your goals and circumstances. It requires careful planning, so look beyond the headlines and do your homework!