When it comes to retirement planning, the 4% Rule has grown into a wildly popular heuristic to determine how much retirees can withdraw from their portfolios each year without running out of money. But does the 4% Rule still work in 2021? Let’s talk about three shortcomings of the 4% Rule and how it can still be applied to your retirement planning.
Safe Withdrawal Rates
The 4% Rule arose from William Bengen’s 1994 study on maximum safe withdrawal rates for retiree portfolios. This research was expanded upon in 1998 by a group from Trinity University, resulting in the now-famous Trinity Study.
While groundbreaking at the time, the initial scope of these analyses was relatively simple. Some of the underlying assumptions included:
- A retirement period of 30 years,
- A portfolio of 50% diversified stocks and 50% long-term corporate bonds, and
- Asset class returns and inflation assumptions would match historical averages.
What Bengen found was, 95% of the time, a 4% withdrawal rate would not deplete an investor’s portfolio over a 30-year retirement. Of course, this starts to sound like a lot like the scene from Anchorman – “They’ve done studies, you know. 60% of the time, it works every time.” It doesn’t imbue you with confidence.
Noting the potential volatility of long-term corporate bonds, Bengen re-ran the study using intermediate-term treasury bonds instead. With this change, he discovered a 100% success rate for the 4% Rule.
Over the years, these studies have been picked apart, modified, and recreated with more nuance. Notably, Wade Pfau updated the original Trinity Study in 2015, painting a more sobering picture around the probabilities of using a 4% withdrawal rate over 30 years.
With this background, let’s now examine three shortcomings of the 4% Rule.
Shortcoming #1: Interest Rates
The first potential shortcoming of the 4% Rule is the use of historical data for bond returns. Interest rates have been steadily declining since 1980 – that’s a 40-year bull run for bonds. As a reminder, when interest rates decrease, bond values increase.
Graphic from Macrotrends.net
Unfortunately, there isn’t much room left for interest rates to decline. As of the writing of this blog post, the current 10-Year Treasury yield is 1.37%. It’s hard to imagine a scenario where bond returns going forward are higher than what we’ve seen over the last four decades simply due to the mechanics of interest rates. This would negatively impact the calculations behind the 4% Rule.
Shortcoming #2: Inflation
In 2021, inflation has become a hot topic within the financial media. Indeed, we’ve all experienced higher prices lately in housing, cars, fuel, and at the grocery store. I’m still upset that the Treehouse has stopped offering their crab cake benedict because of pricing issues.
Where this could potentially compromise the 4% Rule lies in the inflation assumptions. The original studies behind the 4% Rule did include inflation in their calculations; they assumed that after the first year, the withdrawals would increase annually according to the Consumer Price Index (or CPI).
For example, if a retiree has a $1 million portfolio and uses the 4% Rule, the first year’s withdrawal would be $40,000. ($1,000,000 * 4% = $40,000). Assuming that CPI for that year is 2.0%, the next year’s withdrawal would be $40,800. ($40,000 * 2.0% = $40,800) This would occur again in year three, and so on.
The potential dangers here are twofold. First, the inflation that retirees experience from this point could be higher than historical trends. The second danger related to inflation is the CPI number itself. Over the years, CPI calculations have been continually modified so much that some argue they no longer reflect actual inflation felt by U.S. consumers. Does the 4% Rule still work if the inflation assumptions are significantly higher? If it were my retirement, I would certainly want a more in-depth analysis.
Shortcoming #3: Historical Returns
Finally, the use of historical stock returns in the research behind the 4% Rule calculations could potentially impact its use in the real world. Given current market valuations, there is a non-zero probability that we see lower-than-historical return numbers over the next 5 to 10 years. Again, any negative trend in the assumptions behind the 4% Rule could call into question whether it works as a retirement withdrawal strategy.
Let’s not forget that the sequence of investor returns in retirement matters. Two retirees may have identical average returns over 30 years, but the one with lower initial returns will need to reduce their withdrawal rates to make up for a slow start.
Does the 4% Rule Still Work in 2021?
Just like any math equation or computer program, “garbage in, garbage out” applies to the 4% Rule. Understanding all the assumptions behind the original studies is important when applying them to a real retirement scenario. This is where hiring a fee-only financial advisor can be helpful.
That being said, we shouldn’t ignore the 4% Rule either. It’s still a useful tool in our toolkit and is a great first step in the retirement planning process. It’s a perfect back-of-the-envelope method to give us a reality check during the years preceding retirement.
If you’d like help in developing a retirement withdrawal strategy that goes beyond the simple 4% Rule, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.
As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.