Rethinking Retirement: Moving Past the 4% Rule

Rethinking Retirement: Moving Past the 4% Rule – When a close friend turned 50, she began to grapple with one of the most common and pressing questions of midlife: “How much do I need to retire comfortably?” Her concern was not just a matter of finances but a profound reflection on the life she envisioned for herself in retirement. Answering this question is far from simple. It’s not just about crunching numbers; it’s about painting a picture of the life you want and figuring out how to fund it.

For women, the question is particularly significant, as they often face longer retirements due to higher life expectancies. About one in four 65-year-old women will live past age 90, and one in 10 will live past 95. But it’s not just longevity that adds complexity; women are also more likely to experience costly long-term care events, such as extended nursing home stays or in-home care, which can drain their retirement savings. Addressing these realities requires careful planning.

Background

In 1994, financial advisor William Bengen  introduced the time-honored and sometimes controversial 4% rule as a guideline to help retirees manage cash flow as they navigate these uncertainties. His guidelines suggested that a retiree should be able to withdraw 4% of their savings and then withdraw the same dollar amount, adjusted for inflation, every year thereafter for approximately 30 years. He argued that this method gives people an excellent chance of not outliving their money.  

The scenario he set up was simple: a new retiree makes plans to withdraw an inflation-adjusted amount from their savings at the end of each year for a 30-year retirement period. For a 65-year-old, this assumes they pass away at 95, which Bengen felt was reasonably conservative. He analyzed 75 years of U.S. market data and found that a 50/50 asset allocation (stocks and bonds only) could withstand a withdrawal rate of 4.15% at most, even with the worst market scenario (including the Great Depression).

What resulted was the “4% rule.” Bengen never intended for his findings to be a rigid mandate or rule but rather a guideline based on historical data. 

That would mean that someone with $1 million in savings and investments who followed the 4% rule would be able to spend an inflation-adjusted $40,000 each year in retirement. 

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4% Rule Limitations

This framework became a cornerstone of retirement planning but has sparked ongoing debate. In a 2020 interview with Michael Kitces, Bengen himself said, “The number has haunted me for years since then because you know that one number cannot represent the experience of so many different retirees. There are just too many dimensions to the problem to have a one-number solution.”

Furthermore, some of the assumptions Bengen used in 1994, such as a 30-year retirement horizon, may no longer hold true in an era of longer life expectancies and evolving financial landscapes. Today’s retirees are navigating a new world—one where the only constant is change. Global economic uncertainty, geopolitical risks, and technological disruptions have introduced increased volatility into the financial markets, making it more challenging to forecast future returns.

Also, the 4% rule assumes withdrawals are net of taxes and investment fees. In reality, these rising costs can significantly reduce the size of someone’s retirement nest egg.

In response, studies have proposed modifications to the 4% rule. For instance, a 2022 Morningstar study recommended a starting withdrawal rate of no more than 3.8%, compared to 3.3% in 2021, to maintain a 90% probability of not running out of money over a 30-year retirement period.

While any withdrawal rate rule aims for sustainability, none can guarantee that retirement savings will last indefinitely. Market downturns or unexpected expenses can quickly deplete savings.

For example, if a retiree starts with $1,000,000 and follows the 4% rule, withdrawing $40,000 in the first year, a 30% market drop would reduce their portfolio to $660,000 by year-end. This 34% decline severely impacts the portfolio’s ability to recover, even if markets rebound in subsequent years. Continuing withdrawals from a diminished balance increases the risk of running out of money, illustrating how early losses (known as sequence of return risk) can undermine the sustainability of the 4% rule.
Another limitation of the 4% rule is its assumption of a fixed lifestyle, with inflation-adjusted withdrawals remaining constant each year. In reality, retirees’ spending often fluctuates, influenced by health, travel, and lifestyle changes.

How Much do I Need in Retirement?

This deceptively simple question is similar to walking into a doctor’s office and asking, “What do I need to stay healthy?” Just as there’s no one-size-fits-all answer for health because it depends on factors like your age, lifestyle, genetics, and habits, there’s no universal rule of thumb for retirement savings. As famed philosopher Socrates said, “Know thyself.” This wisdom applies as much to retirement as it does to life; understanding your own priorities and values is the cornerstone of planning.

Three Guiding Retirement Principles

Here are three guiding principles that can help create a plan that can work for you:

1. Personalization: Your goals are the driver of retirement savings. Think about what retirement looks like for you, how often you want to travel, and where you want to live. Think of hobbies, family support, or healthcare needs, and let those priorities guide your planning.
   
2. Flexibility: Life and markets are unpredictable, so your plan should adapt to changing circumstances. Instead of rigid rules, aim for a strategy that adjusts withdrawals based on what’s happening in the market or in your life. This flexibility can help your savings last longer, especially if unexpected expenses arise.
   
3. Regular Reassessment: Life constantly changes, and your goals and financial situation evolve. Revisiting your plan regularly can help keep you on track and your strategy aligned with your current needs and future aspirations. As Winston Churchill wisely noted, “To improve is to change; to be perfect is to change often.”

Implementation

To implement these principles effectively, you can leverage the following strategies:

1. Income Strategy:
   Broadly speaking, a well-designed portfolio has two main footprints: returns and yields. Returns are the money the portfolio makes from selling assets for a profit, and yields are interest payments from bonds and dividends from stocks. Combining yield with other sources of income like Social Security, pension, rental property, or other passive income sources can help establish stable, long-term income for your retirement. Creating a portfolio that maximizes yields will help increase its longevity.
   
2. Tax Advantaged Withdrawal Strategy:
   Most retirement portfolios fall within three categories:
   • Taxable (e.g. brokerage accounts)
   • Pre-tax (e.g. IRA, 401(k))
   • Post-tax (Roth IRA)
   
   One retirement income strategy is to structure your withdrawals around letting your most tax-advantaged accounts grow longest and sequence your withdrawals to minimize the tax impact, e.g. drawing from taxable accounts first, then tax-deferred accounts, and leaving Roth accounts for later. However, you’ll need to consider your income and tax situation to decide which order will work best for you. As your finances change, you may also decide to adjust the order. For example, if you land in a higher-than-usual tax bracket one year, withdrawing from a tax-exempt account, such as a Roth IRA, may help you avoid higher marginal tax and falling into a higher IRMAA bracket.
   
3. Guardrails approach:
   The guardrails method sets an initial withdrawal percentage and adjusts subsequent withdrawals annually based on portfolio performance and the previous withdrawal percentage. For example, increase spending in strong market years and cut back during downturns to preserve principle. This method helps balance your lifestyle needs with portfolio longevity. Pair this with a bucket strategy, which separates assets into short-term, medium-term, and long-term and uses different investment strategies for each bucket.

By combining these strategies with the foundational principles of personalization, flexibility, and regular reassessment, you can create a retirement plan tailored to your needs.

Financial advisors, like doctors, use various diagnostic tools and strategies to craft personalized plans that help clients work toward the lifestyle they desire. This involves analyzing income sources, goals, investment returns, risk tolerance, risk capacity, and challenges like long-term healthcare costs or market volatility. 

Crucially, all investment plans require subjective human judgment to align with individual needs. Remember, the best approach is one tailored to your life and goals.

Sources:

https://www.firstlinks.com.au/the-creator-of-the-4-rule-and-his-own-retirement
https://www.barrons.com/articles/life-expectancy-retire-educated-guess-6bf1c7c1?utm_source=chatgpt.com

This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from Savant. Please consult your investment professional regarding your unique situation.

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Ritu Jain Financial Advisor CEP®, EA

Ritu enjoyed a 20+ year career as an entrepreneur in technology and has a background in engineering. She brings a unique perspective and a diverse skillset with focus on client service and leveraging technology to meet client needs.