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It's time to retire the 4% rule

| December 09, 2016
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One of the more challenging tasks for families is determining how much money they can withdraw from their investment accounts each and every year during retirement. The task is challenging because most families want to make sure they don’t run out of money later in life, and they cannot possibly predict all of the things that could impact their income and expenses throughout retirement. Various factors, such as ages of family members, interest rates, asset allocation, order of portfolio returns, and human factors should be considered when determining an annual withdrawal amount.   

One of the more commonly known and used “safe withdrawal rates” is the 4% rule, made popular as a result of various research studies conducted in the 1990s. The research concluded that retirees with a diversified portfolio balanced between stocks and bonds can safely withdraw 4% of their initial balance at retirement, adjusting the dollar amount for inflation each year thereafter. For example, a family with a $300,000 IRA could withdraw $12,000 in their first year of retirement. Aside from the fact that rules are often imprecise when applied to precise situations, here is why I believe it is time to retire the 4% rule.

First, any withdrawal strategy should consider the ages of the family members. Certainly, someone who is retiring at age 55 can’t maintain the same withdrawal rate as someone who is retiring at age 70. And, shouldn’t a couple with a small age difference (say age 67 and 65) be able to take a higher withdrawal rate than a couple with a large age difference (say age 70 and 58)?

Second, interest rates today are as low as they have been in my adult lifetime. Low bond yields and rates on bank certificates of deposit are making it difficult for retirees to live on the income from these types of investments. Isn’t it intuitive that withdrawal rates should be lower when interest rates are lower?

Third, research behind the 4% rule assumes a specific mix between stocks and bonds. When applying the 4% rule, is the mix of stocks and bonds in a family’s portfolio the same as that which was used in the research? If so, is it reasonable to expect a family to maintain this mix for the duration of their retirement? Often, investment strategies become more conservative as families age; does the 4% rule still apply in this case?

Fourth, we can all agree that we have no control over the direction of the stock and bond markets. We do know, however, that low or negative returns early in retirement have a more adverse impact on sustainability of income than the same low or negative returns later in retirement. Shouldn’t a withdrawal rate be adjusted down if large negative returns occur early in retirement? Can a family who retired in 2008 and experienced a 40% drop in the value of their investments maintain the same 4% withdrawal rate adjusted for inflation?

Finally, there is the biggest factor of all, the human factor. As is the case with most research, the 4% rule is based on a very stringent set of guidelines that very few families would be able to maintain starting with the proper initial allocation between stocks and bonds; choosing investments that are based on the indices used in the study; rebalancing per the research guidelines, adjusting the annual withdrawal amount up or down based upon inflation; and the biggest human factor of all – not withdrawing more than the rule says in any one year.

Creating reliable retirement income over a period of two to three decades is a complex task. Mistakes can be catastrophic. There are so many guidelines and rules of thumb presented on the internet. How do you know what will work? How do you know which ones are outdated? Are you willing to “roll the dice,” only to be without sufficient income to pay routine expenses or proper health care as you age? You see, you won’t know if the rules of thumb work – until it’s too late. So, let’s retire the 4% rule and create a customized, dynamic income strategy that works during your second half!

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. 

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. 

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