The 4% rule, a popular retirement income strategy, may be outdated

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Market conditions are pushing the 4% rule, a popular rule of thumb for retirees, to determine how much money they can live on each year without fear of running out later.

Raising money from his nest egg is among the most complex financial exercises for households. There are many unknowns – the length of retirement, one’s consumption needs (e.g., health care costs) and return on investment, to name a few.

The 4% rule is intended to provide a uniform flow of annual income and provide seniors with a high degree of comfort with the fact that their funds will last over a 30-year pension.

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Simply put, the rule states that retirees can deduct 4% of the total value of their investment portfolio in the first year after retirement. The dollar amount rises with inflation (the cost of living) the following year, as it would do the following year, and so on.

However, market conditions – namely lower expected returns for equities and bonds – do not appear to work in favor of pensioners.

Given market expectations, the 4% rule is “perhaps no longer feasible” for seniors, according to a paper published Thursday by researchers at Morningstar. These days, the 4% rule should really be the 3.3% rule, they said.

Although the reduction may sound small, it can have a major impact on the standard of living of pensioners.

For example, using the 4% rule, an investor will be able to withdraw $ 40,000 from a $ 1 million portfolio in the first year after retirement. But using the 3% rule, the first-year withdrawal drops to $ 33,000.

The difference would be more pronounced later in retirement when inflation is taken into account: $ 75,399 against $ 62,205, respectively, in the 30th year, according to a CNBC analysis. (The analysis assumes an annual inflation rate of 2.21%, the average projected by Morningstar over the next three decades.)

Why 3.3%?

Retirees have enjoyed a “trifecta” of positive market developments over the past few decades, according to Christine Benz, director of personal finance and retirement planning at Morningstar and co-author of the new report.

Low inflation, low bond yields (which have increased bond prices) and strong stock returns have helped strengthen investment portfolios and secure withdrawal rates, she said.

The dynamics may have lulled near-retirees into a false sense of security, Benz said.

It is “very unlikely that bonds will enjoy strong gains over the next 30 years,” and high stock prices are likely to fall when they return to average, according to the report. The analysis admits that this result is probable, but not inevitable.

(While inflation has been historically high in recent months, Morningstar expects it to decline in the long run.)

Investment returns are particularly important in the early years of retirement due to the so-called return on risk. Taking too much out of your nest egg in the first year or years – especially from a portfolio that is also declining in value – can greatly increase the risk of running out of money later.

This is because there is less room for the portfolio to grow once investments return.


Of course, there are ample reservations to this analysis of the 4% rule.

First, the 4% rule (and the updated 3.3% rule) only take into account one’s portfolio investment. It does not take into account non-portfolio sources of income such as social security or pensions.

Retirees who delay claiming social security for 70 years, for example, will receive a higher guaranteed monthly income stream and may not have to rely so much on their investments.

Further, the rule of thumb uses conservative assumptions. For example, it uses a 90% probability that seniors will not run out of money over a 30-year pension.

Retirees who are familiar with more risk (i.e., a lower probability of success), or who think they will not live up to the 90s, can certainly raise larger amounts each year. (A 65-year-old today will live another 20 years on average.)

The most important thing is that the rule assumes that one’s expenses do not adapt to market conditions. But that may not be a reasonable assumption – research shows that seniors generally fluctuate their expenses through retirement.

Retirees have a few options in this regard to ensure the longevity of their investments, according to Morningstar. In general, these require smaller withdrawals after years of negative portfolio returns.

For example, retirees may waive inflation adjustments in these years; they can also choose to reduce their typical withdrawal by 10% and return to normal when the return on investment is positive again.

“There are some simple adjustments you can make,” Benz said. “It does not have to be one gigantic strategy; it can be a series of these step-by-step adjustments that can make a difference.”

However, there are trade-offs of being flexible. Essentially, these annual adjustments to spending can mean large fluctuations in one’s standard of living from year to year.


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