Market conditions are pressuring 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.
Withdrawing money from one’s nest egg is among the most
complex financial exercises for households. There are many unknowns — the
length of retirement, one’s spending needs (health costs, for example) and
investment returns, to name a few.
The 4% rule is meant to yield a consistent stream of annual
income, and give seniors a high degree of comfort that their funds will last
over a 30-year retirement.
Simply, the rule says retirees can withdraw 4% of the total
value of their investment portfolio in the first year of retirement. The dollar
amount increases with inflation (the cost of living) the following year, as it
would the year after, and so on.
However, market conditions — namely, lower projected returns
for stocks and bonds — don’t seem to be working in retirees’ favor.
Given market expectations, the 4% rule “may no longer be
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
Though the reduction may sound small, it can have a big
impact on retirees’ standard of living.
For example, using the 4% rule, an investor would be able to
withdraw $40,000 from a $1 million portfolio in the first year of retirement.
However, using the 3% rule, that first-year withdrawal falls to $33,000.
The difference would be more pronounced later in retirement,
when accounting for inflation: $75,399 versus $62,205, respectively, in the
30th year, according to a CNBC analysis. (The analysis assumes a 2.21% annual
rate of inflation, the average projected by Morningstar over the next three
Retirees have enjoyed a “trifecta” of positive market
developments over the past several decades, according to Christine Benz, the
director of personal finance and retirement planning at Morningstar and a
co-author of the new report.
Low inflation, low bond yields (which have boosted bond
prices) and strong stock returns have helped buoy investment portfolios and
safe withdrawal rates, she said.
The dynamic has perhaps lulled near-retirees into a false
sense of security, Benz said.
Bonds are “highly unlikely to enjoy strong gains over the
next 30 years,” and high stock prices are likely to fall as they revert to the
average, according to the report. The analysis concedes that this result is
likely though not inevitable.
(While inflation has been historically high in recent
months, Morningstar expects it to moderate over the long term.)
Investment returns are especially important in the early
years of retirement due to so-called sequence-of-returns risk. Taking too large
a withdrawal from one’s nest egg in the first year or years — especially from a
portfolio that’s declining in value at the same time — can greatly increase the
risk of running out of money later.
That’s because there’s less runway for the portfolio to grow
once the investments rebound.
Of course, there are ample caveats to this analysis of the
For one, the 4% rule (and the updated 3.3% rule) only
consider one’s portfolio investments. It doesn’t account for non-portfolio
income sources like Social Security or pensions.
Retirees who delay claiming Social Security to age 70, for
example, will get a higher guaranteed monthly income stream and may not need to
lean on their investments as much.
Further, the rule of thumb uses conservative assumptions. For
example, it uses a 90% probability that seniors won’t run out of money over a
Retirees comfortable with more risk (i.e., a lower
probability of success) or who think they won’t live into their 90s may be able
to safely withdraw larger amounts of money each year. (A 65-year-old today will
live another 20 years, on average.)
Perhaps most significantly, the rule assumes one’s spending
doesn’t adjust according to market conditions. But that might not be a fair
assumption — research shows that seniors generally fluctuate their spending
Retirees have a few options in this regard to ensure the
longevity of their investments, according to Morningstar. Generally, these call
for lesser withdrawals after years of negative portfolio returns.
For example, retirees can forgo inflation adjustments in
those years; they may also choose to reduce their typical withdrawal by 10%,
and revert to normal once investment returns are again positive.
“There are some simple tweaks you can make,” Benz said. “It
doesn’t have to be one giant strategy; it can be a series of these incremental
tweaks that can make a difference.”
However, there are tradeoffs to being flexible. Chiefly,
making these annual adjustments to spending might mean big swings in one’s
standard of living from year to year.
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