Clients of ours are familiar with the 4% rule. This rule is more like a guideline that has helped financial advisors develop long-term plans for their clients for years. The original creation of this rule is credited to William Bengen who had a goal of simplifying the retirement planning process and giving retirees a target number to shoot for that would be financially sustainable in retirement.
Here's how it works. The 4% rule says that a withdrawal rate of 4% out of an investment portfolio, assuming the portfolio is diversified evenly among S&P 500 companies and Treasury bonds, should be sustainable long-term, adjusted for inflation.
Consider that since the 1920s, the S&P 500 has had an average annualized return of 10.5%. This means if your portfolio is invested in the S&P, you should be able to safely withdraw 10.5% ...right?
Well, not quite. You first need to consider three things.
1) Inflation needs to be accounted for since it deflates the purchasing power of your money. Most advisors factor inflation to be roughly 3% annually, which means your portfolio needs to grow at least 3% each year to keep up with inflation.
2) We also need to remember that 10.5% is the annual average. Some years it is lower than that. We need to arrive at a withdrawal rate that is conservative so it can be relied upon for long-term sustainability.
3) Retirees are likely not going to be invested in a portfolio that mirrors the S&P. While at Summit we like to encourage retirees to stay invested in equities, we often opt for more conservative investment strategies in retirement to hedge against market volatility.
Therefore, a 4% withdrawal rate can be both realistic and sustainable long-term. In addition, chances are with a 4% withdrawal rate out of a carefully constructed portfolio designed by a competent professional, the principal balance of the portfolio would rarely need to be touched. This means when you pass away, the balance of the portfolio can be passed on to your heirs.
Since retirement has become longer and longer as life expectancy numbers rise, a method that can work for any time horizon is critical – and that’s where the 4% rule comes into play. But it leads us to a question. Since inflation is often referred to as the silent killer of a retirement portfolio, how does the 4% rule come into play, and should we adjust this rule in years where inflation is higher?
“What if inflation is higher than 3%?”
It is a fair question. Inflation so far in 2022 has been on historically high trends. In January of 2022, we saw inflation climb to 8.5%!
Does that mean we should abort the 4% rule for a more conservative number? Probably not. Here’s why.
The whole original goal of the 4% rule was to take a conservative approach which means it still stands in times when the market doesn't perform the way we would like it to. When William Bengen developed the 4% rule, this wasn’t a number he pulled out of thin air, he actually looked at the complete history of the stock dating back to 1926 and attempted to discover what is the highest locked-in withdrawal rate over a 30-year period without losing any portfolio principal value for a given year.
Interestingly, he found that the worst year to start a 30-year retirement would have been 1968. So, what was the dismal rate that would still be sustainable if constructing a portfolio of 60% S&P stocks / 40% Treasury bonds in 1968? 4.5%.
That’s where the 4% rule comes from. You see, 4% is not the average. It is, if you had started retirement in the worst year possible in the history of the stock market, it would still sustain you.
This means the 4% rate stood up against the Great Depression, several stock market crashes, Black Monday, world wars, and high inflationary periods. And yes, it still holds against the 2008 Great Recession and Covid.
The point is this: news outlets have a way of making investors feel like we are in unprecedented times. Wars, inflation, recessions, market corrections... these are all things that can cause uncertainty, fear, and panic, but they have all happened before.
Perhaps we are in unprecedented times. However, with over 100 years to look back on the stock market, there has yet to be an event or situation where the stock market doesn’t recover, and that is unlikely to change now.
Finally, realize that the 4% rule is a conservative and solid rule of thumb. Detailed financial planning can help you lock in on a number that is more specific to you and your portfolio, as there are many variables that might change the ideal withdrawal rate for you.
If you are young and have years or decades before your eventual retirement, consider the 4% rule. What income will sustain you in retirement? Knowing 4% is a safe withdrawal rate, work backward, and reverse engineer it to help you come up with a savings goal that will allow you to live off of your investment portfolio. This can be an incredibly helpful tool in your retirement planning process.