The 4% rule is back, but it's not really a rule

One of the most controversial numbers in financial planning, 4%, is back — but the “rule” that follows it less so.

On Monday, Morningstar Inc. published research showing that 4% is the “highest safe starting withdrawal rate for retirees,” as there is a 90% probability they will still have money left in their portfolios after 30 years, assuming an initial allocation to equities of 20% to 40%.

That is a couple of notches of a percentage up from the drearier withdrawal rate of 3.3% the company identified in 2021, which was markedly lower than the 4% made famous in the mid ’90s by financial advisor Willliam Bengen. By comparison, the rate Morningstar researchers cited last year was 3.8%.

Behind that are a couple main factors: higher fixed-income yields and lower expectations for long-term inflation.

“The famous 4% rule that started with Bill Bengen was looking at what was historically sustainable,” said Amy Arnott, portfolio strategist at Morningstar and one of the authors of the new research. “This is a little bit different, in that it’s forward-looking. And it’s not just assuming a single rate of return … We’re running a thousand different simulations and looking for the withdrawal rate that succeeds in 90% of those.”

Although the highest safe withdrawal rate over 30 years was 4% for portfolios with 20% to 40% stock exposure, the rate decreased for allocations outside of that range. For portfolios entirely in equity, the rate was just 3.3%, and for those holding no equities, it was 3.6%, Morningstar found.

The 20% to 40% equity weightings also showed the highest safe withdrawal rates over other time frames, which ranged from 10 years to 40 years.

However, portfolios more heavily allocated to stocks had higher ending balances after 30 years — a result that poses questions for retirees who are concerned about legacy assets.

DON'T CALL IT A RULE

Although it’s long been referred to as the “4% rule,” advisors say they hardly treat it as such. More often, it’s a starting point or a guideline. But some call it downright dangerous.

“If we did 4% in 2022 with both the stock market down and the bond market eviscerated, it would be hard to make up for those losses,” Ronald Palastro, financial planner at Cobblestone Wealth Advisors, said in an email. “Today we have products designed for retirement and software capable of creating segments to protect a retirement nest egg against sequence-of-return risk. The 4% rule is simple and dangerous.”

Sean Lovison, founder of Purpose Built Financial Services, said he recommends “a dynamic guardrail strategy” that adjusts withdrawals in response to financial circumstances and market changes, which provides a balance between flexibility and security.

“While [4% is] a helpful starting point, I believe it can be overly simplistic and potentially risky to apply this uniformly across all clients,” Lovison said in an email.

Another advisor, Nicholas Gertsema, CEO of Gertsema Wealth Advisors, wrote that “there is no such thing as a Rule of 4%,” calling the idea “a misapplication” of Bengen’s study based on historical returns.

“The biggest myth in retirement income planning is that the retiree will spend an equal amount every single year increased only by inflation. There are three stages of retirement income: the go-go, slow-go, and no-go years,” Gertsema said in an email. “We understand that the first years of retirement tend to be the most expensive, but we make sure to plan for later years as well. We use bucketing to tell the story visually so our clients understand what their income will be for the next two years if there are bad markets.”

Spending in retirement begins high and then typically declines, with research showing that it also often increases toward end of life, said David Foster, founder of Gateway Wealth Management.

“If you assume a client's spending will keep up with 100% of inflation, you're going to conclude that they need a lot more money than they're likely to need, which might cause them to either spend less or work longer than they need to,” Foster said in an email. “I prefer to start with the assumption that a client's spending will keep up with 80% of the inflation rate and then adjust from there according to the unique circumstances of the client.”

Steven Stanganelli, advisor at Clear View Wealth Advisors, sometimes starts recommendations at 4.5%, adjusted with the help of software for inflation and portfolio performance. But that strategy can be limited, he said.

“An income-focused portfolio can be positioned to generate 6%, 7% or [more than] 8% if it includes income-generating investments like closed-end funds,” he said in an email. “Oftentimes, these investments will be comprised of the same elements as many mainline index funds. But because of the way CEFs are structured, they can produce a higher yield than even just holding the stocks that make up the index (like the FAANG stocks).”

BIG EXPENSES

Of course, one thing that can throw a rate of 4% right out the window is a financial shock, such as high medical bills.

A way to help account for that is to have assets in “buckets” that are designated for different purposes — but allocations to annuities can also be useful, Morningstar's Arnott said.

“One strategy you could consider would be purchasing an annuity to cover a portion of your living expenses, especially for things that are absolutely essential that you’re not able to cover with Social Security, and then use the investment portfolio to cover things that are more discretionary,” she said.