Bill Bengen first devised the 4% retirement rule in 1994. Since then, retirees have relied on this rule to help determine how much they should spend in retirement. The rule is relatively simple. You add up all of your investments, and withdraw 4% of that total during your first year of retirement. In later years, you adjust how much you withdraw to account for inflation.
So if you have $1 million saved for retirement, you would spend $40,000 the first year, and if inflation is 2% the following year, you would take out $40,800 that year. The 4% rule assumes that when you retire, your portfolio is 50% stocks and 50% bonds.
Based on Bengen’s original paper, this approach would have protected retirees from running out of money during every 30-year period since 1926, even when considering the Great Depression, the tech bubble, and the 2008 financial crisis. However, due to the combination of high inflation and high stock and bond market valuations, Bengen believes retirees will need to make some adjustments to their spending.
Cut spending now
Bengen, who retired in 2013, suggests that given today’s unprecedented economic situation, retirees will need to cut back their spending and lower their withdrawal rate. A recent Morningstar study shows that the 4% withdrawal rate was too aggressive. Its research recommends a 3.3% starting withdrawal rate.
This assumes a 50/50 stock and bond portfolio and a 90% degree of certainty of not running out of funds over a 30-year timespan. The key thing it found was that the more flexible retirees are with their spending, the greater the chance they can raise the withdrawal rate over time.
Impact of high inflation and high stock valuations
The average U.S. inflation rate since 1913 has been 3.1%. With inflation now at 8.3%, withdrawals under the 4% rule increase considerably. This means the portfolio will need to earn higher returns or there is a greater chance the portfolio will be depleted.
Another issue Bengen raises is that stock valuations are at a historic high. Stocks are now trading at about 36 times corporate earnings over the past decade. Bengen states, “This is double the historical average. While low interest rates justify higher stock valuations to some extent, I think the market is expensive.”
When stock valuations are high, a bear market normally follows to bring prices back to their average. So there is a good chance there may be a recession or bear market in the near future, if we aren’t already in one currently. During these periods, retirees will need to be even more cautious about making withdrawals to ensure they don’t run out of money.
After reducing their spending, Bengen recommends that retirees reduce their exposure to stocks and bonds. This would decrease their risk should there be a recession or bear market. By having more cash or other assets such as income-producing real estate, when the market drops, there may be an opportunity to purchase stocks when they are cheaper. Retirees need to be careful, though. The important thing is to not try to time the market, as this can lead to even greater issues.
Based on today’s economic conditions, retirees will need to rethink the popular 4% rule. Experts, including the creator of this popular retirement income strategy, believe it is outdated and retirees should evaluate their financial plans and spending to manage the risk of running out of money. The key is to be flexible with your finances and keep a long-term financial view.