What is the 4 per cent rule, how does it work and is it reliable?
The 4 per cent rule is a rule of thumb that helps investors easily calculate how much they need to save in order to ‘live off the earnings for the rest of their life’. Without this guideline, it would be very difficult for most people to plan for decades of non-working life without worrying about running out of money.
William Bengen was a financial adviser who was looking to answer the question, “what is the safest maximum withdrawal rate an investor can withdraw and have a high probability of leaving their savings intact for their entire retirement?”
Bengen looked at countless simulations of historical returns. He concluded that a draw-down rate of 4.2 per cent (or less) was the safe rate. In October 1994, Bengen’s research was published in the Journal of Financial Planning and it soon became known as the ‘4 per cent rule’.
Retirement planning involves people, feelings and many other non-static factors. It can be more complex than simply saving $2 million and paying yourself $80,000 per annum forever.
Below we have a look at some of the reasons why relying on simple arithmetic isn’t the silver bullet to shaping your lifetime savings habits.
What did the investment portfolio look like?
Bengen used a portfolio of 60 per cent shares and 40 per cent bonds.
This mix is higher risk than many retirees are comfortable with, so this can impact its application.
Having more in lower returning assets will result in a lower long-term return, so the safe withdrawal rate is dependent on the investment mix of each household.
Being able to follow the 4 per cent rule year-in, year-out for 30 years is highly unlikely.
It is easy enough to run a model where the withdrawal rate is set and forget. But life produces unexpected events (did someone say 2020?). As a result, it can be difficult to actually keep to the same strategy for 30 years without deviating.
Conservative investors might want to withdraw less or skip the inflation adjustment during bear markets to help the portfolio recover. It can also be tempting to take out a little extra when returns are booming.
The rule is designed to work over a 30-year period, which will practically never be your timeline.
If you stop work at age 54 the duration of your non-working life is much different to someone who stops work at age 73.
Early retirees with a longer time horizon may need to play it safe at the beginning of retirement. This is because the 4 per cent rule doesn’t account for retirement time frames beyond 30 years.
But being frugal can be a tough ask when you are fit and in your 50s and have a bucket list to work through.
Timing of returns
Sequencing, or the order of returns, can have a huge impact on how long money will last.
Take for example someone who retired in January 2008, during the Global Financial Crisis. Along with paying themselves 4 per cent per year, their portfolio declines by almost 30 per cent within 18 months of retirement. Having such a depleted portfolio so early in retirement can make it very difficult to not run out of money.
There is some good news, however. Withdrawing 4 per cent each year isn’t the average sustainable distribution rate, but the lowest fail-safe rate meant to deal with the worst-case scenario for a 30-year investment period. For many starting periods, withdrawing 5 per cent (or some cases even up to 6 per cent) would have been plenty safe. This would see you with your savings intact at the end of 30 years.
The lesson from my decades in financial planning is to recognise that future investment returns and household expenses are unknown. While following the 4 per cent rule is a good place to start, when it comes to investing, nothing is guaranteed. This is why Nobel Prize winner, William Sharpe, said retirement income planning is “the hardest and nastiest problem in finance.”