The ‘4% rule’ still works — maybe

Preparing for retirement usually takes decades of saving and investing, but that’s often only half the battle. There…

Preparing for retirement usually takes decades of saving and investing, but that’s often only half the battle. There are two key variables to monitor for retirement: growth of assets and rate of spending. When it comes time to tap into their nest eggs, retirees need to know how much they can safely spend from their investments to have a reasonable expectation that they will not outlive their savings.

One simple guideline that has shown remarkable effectiveness and resiliency over time is the so-called “4% rule,” which essentially states that withdrawing 4% of the value of a diversified portfolio in the first year of retirement, and increasing that dollar amount annually by the rate of inflation, will not exhaust the principal balance after 30 years. Financial planner William Bengen originally popularized the 4% rule of thumb in a 1994 Journal of Financial Planning article showing that, in every 30-year period since 1926, annual inflation-adjusted withdrawals of 4% from a diversified portfolio, invested 50% in stocks via the S&P 500 Index and 50% in intermediate-term U.S. Treasury securities, resulted in a surplus of savings that was sometimes substantial.

“ In no past case has it caused a portfolio to be exhausted before 33 years, and in most cases it will lead to portfolio lives of 50 years or longer,” writes Bengen, who also found that allocations of up to 75% in stocks produced longer portfolio lives, despite the additional volatility.

Subsequent research from three professors at Trinity University in 1998 confirmed and expanded upon Bengen’s findings and led to wide adoption of the 4% rule as a benchmark in retirement planning. After Bengen’s initial study, there were some 30-year periods that began in the mid-1960s for which a 4% withdrawal rate starting point completely depleted a portfolio in less than 30 years, thanks to periods of high inflation and extended bear markets. Despite these occasional exceptions, the more frequent complaint about Bengen’s system is that a 4% withdrawal rate is actually too conservative; a number of academics who have investigated the data point out that 4% spending often leaves a “surplus” of unspent wealth.

The simplicity of the 4% rule is extremely appealing, but in the wake of the 2008–2009 financial crisis, and with the possibility of persistently below-average returns, can it still work? As with most things, the definitive answer is, “it depends.” Several factors affect how much may be withdrawn from a portfolio to maximize longevity, including the impact of taxes and fees on investment returns, asset allocation of the portfolio and future inflation rates. Also, there may be other considerations, such as a desire to leave something for heirs or charity instead of completely spending down savings over a 30-year retirement.

Looking at the numbers

With all of the moving parts, the bottom-line consideration for most investors is whether following the 4% rule will allow their nest egg to last as long as their retirement if stocks go through a prolonged period of underperformance. By making some assumptions about inflation, investment returns and taxes, several simple scenarios illustrate that, indeed, spending 4% a year, plus a cost of living adjustment, is a fairly conservative withdrawal rate and provides a high probability of success—even with subpar market returns, fees, taxes and inflation.

Although tax rates are always subject to change, for purposes of illustration, assume that stock gains will be taxed at 20% (assuming a mix of long- and short-term capital gains and dividend income) and that bond returns will be taxed as ordinary income at the 35% rate. Additionally, we will assume an inflation rate of 2% a year.

In the first scenario, we have stocks return 10% a year (6% after taxes and inflation), approximately equal to the 9.9% annual return averaged from 1926 through 2010 by the large-cap S&P 500 index. For bonds, we use an annual return of 4%, conservative by historical comparison but perhaps more realistic for decades ahead. With these parameters and using a 4% withdrawal rate plus a 2% annual inflation adjustment, a hypothetical portfolio split evenly between stocks and bonds will decrease by 0.7% a year over the 30-year period and will not be completely depleted for 143 years.

If stocks produce returns that are significantly below average for the 30-year period, say 7% annually pre-tax (3.6% after taxes and inflation), there still appears to be adequate breathing room in a portfolio that is 50% stocks and 50% bonds. In this illustration, combined stock and bond investment returns would average 2.1% a year after inflation and taxes, with the hypothetical portfolio decreasing at a net rate of 1.9% annually. At this pace, the portfolio would not be fully exhausted for 53 years.

Despite the general association of risk with stocks and safety with bonds, it is illuminating to look at the projected longevity of portfolios that are either 100% in stocks or 100% in bonds. Based on the prior assumptions, the all-bond portfolio returns 0.6% annually after inflation and taxes, and decreases at a 3.4% annualized rate after spending. At this pace, the portfolio would be depleted in 29 years.

Contrast this performance with an all-stock portfolio using the estimated returns of the market’s long-term average of 10% annually, or 6% after accounting for the impact of taxes and inflation. Even with 4% of the value going to spending, the net hypothetical portfolio gain is a positive 2% annually. In this hypothetical scenario, the portfolio would never deplete.

Making retirement work

The 4% rule is far from perfect, but in the world of estimating volatile investment returns, the premise is still of good sense. The true question for would-be retirees may be whether 4% of your portfolio will provide enough income to maintain a lifestyle that you want.

For a rough idea of how much you’ll need to have saved by the time you retire, you can use the 4% rule and multiply your desired annual income by 25 to arrive at a target. For example, if you need $100,000 per year in retirement, you’ll need to have $2.5 million stashed away.

While it’s tempting to use recent investment performance when estimating for the future, market returns are historically volatile and past performance is not indicative of future results. Markets are likely to ebb and flow in the future the same way they have done in the past. With help from your advisor, you can map out a plan to put you on the path toward saving enough now to meet your spending goals down the road.

Matthew L. Rubin is the director of investment strategy at Neuberger Berman