Banking & Finance

Will the 4% rule meet my retirement goals?

March 31, 2019
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You’ve planned for your retirement and dreamed of your future, considering what will be important to you in the years after your professional life winds down.

Perhaps for you, it includes traveling to yet unseen places, giving to organizations with common interests or providing for your family after you’re gone. But how will you know what you’ll be able to safely spend in retirement? What valuable experiences should you say no to today, so you can feel certain you will have financial security in the future? And how much can you spend to accomplish the things you’ve dreamed of?

In general, financially successful people spend less than they make for most of their lives. This allows them to build significant savings. If this describes you, the habit of saving can become so ingrained that when you reach retirement, it may feel very uncomfortable to spend from savings. It can feel challenging to balance the desire to enjoy time with family, travel or give to charity with the concern about running out of money. But what if we can improve the opportunity to accomplish both financial flexibility and security?

One widely accepted rule of thumb for spending in retirement is that it is reasonable to spend 4% of an investment portfolio each year. This common understanding is based on research by Bill Bengen, published in 1994. Basically, Bengen said if you have a portfolio that is 50% stocks and 50% bonds, the historical data say you should be able to start your first year of retirement spending 4% and increase this each year by inflation for at least 30 years. This means that regardless of market volatility, including good and bad years, 4% should be a sustainable level over the course of your retirement years. For example, if you start retirement with $2 million, during your first year of retirement, you can withdraw $80,000. You can then plan to increase this amount with inflation each year.

Bengen’s research is very helpful guidance. Importantly, it highlights the need for a diversified portfolio, which will very likely allow you to spend more over time, versus an old-fashioned income portfolio, which typically has meant living off dividends or bank interest, where current rates are 2-3% per year and which may not increase over time with inflation.

What the 4% rule doesn’t account for is the need for flexibility and the changing circumstances that one is likely to experience through retirement. First, no one is likely to invest in a portfolio with two asset classes at the start of retirement and then ignore it for 30 years. You wouldn’t put your life savings in a black box and hope for the best. In reality, most people make the mistake of looking at their investments far too often for good decision making.

If we use the 4% rule, in addition to considering how the years of retirement can necessitate modifications, you can very likely plan to spend more initially and spend more over time. Investing in more than two asset classes and increasing stocks may provide optimal balance of risk and opportunity for growth. Bengen himself later said a more diversified portfolio may increase the sustainable initial withdrawal to 4.5%. Bengen, and many others, have also shown that increasing your allocation to stocks, perhaps up to 75%, could probably improve financial flexibility.

In addition, other research indicates spending changes over retirement for most people. Specifically, it is usually higher in the early years and drops as people age. Later, spending increases again in the final few years of life, often as a result of higher health care spending. In other words, you could potentially  plan to spend more in the first 10 years in retirement, if you are willing to reduce spending later.

Therefore, another area to consider is your willingness to adjust your future spending up or down, depending on how things are going in your portfolio. Practically speaking, most people do this all the time. Economists call this the wealth effect, and it realistically happens whether spending less is really needed. In the wake of the 2008 financial crisis, most people reduced spending at least a little, even if they did not need to.  

Research by Jonathan Guyton says that if you are willing to make incremental 10% adjustments to annual spending along the way, up or down, depending on how your portfolio performs, you could reasonably consider starting retirement with an initial withdrawal of 5.5% or more. For a person with $2 million in retirement savings, the difference between 4% and 5.5% is $30,000 per year in additional spending flexibility. Consider what you would enjoy doing with an extra $2,500 per month or who you could help if you could give that much more to charity, simply by modifying your annual spending.

The best plan depends on what is important to you, and there are many considerations to optimize the path forward. The 4% rule provides helpful guidance for initial decision making, but it is important to recognize that changes may need to be made along the way. You may find you have a lot more financial flexibility and more opportunity to do the things that are important to you — with more careful planning now and in your retirement years.