For years now, financial planners have used something known as the 4% rule to find the sweet spot for retirement spending. The original idea was to prevent retirees from burning through savings and outliving their money, while also avoiding the risk of being more frugal than necessary. The 4% rule offered the promise of a fixed annual withdrawal rate that would provide a predictable income without draining retirees’ assets.
But the thinking that went into calculating the rule some 20 years ago is being called into question now, mainly because the market conditions then were quite different from today’s. And while you can use the 4% rule to think about how much to spend when you retire, it’s really just the jumping-off point for a long-term plan, says Rob Williams, managing director of income planning at the Schwab Center for Financial Research.
How the 4% rule was built
Many analysts and advisors believe that the 4% rule is still a good place to start your calculations. It’s a relatively easy assessment. You add up all of your investments in both taxable and tax-deferred accounts and withdraw about 4% of the total during your first year of retirement. In subsequent years, you adjust that initial amount to account for inflation. So if you have a $3 million nest egg, you can give yourself a starting retirement salary of $120,000. If the cost of living goes up 3% in the first year, you give yourself a 3% raise, to $123,600, in the second year, and so on.
California financial planner William Bengen came up with the rule in 1994, basing it on market history and a hypothetical portfolio split evenly between stocks and bonds. He calculated that for each 30-year period since 1926, anyone following the rule would have had money left over at the end of a 30-year retirement.
But Rob says today’s financial landscape is too variable to rely solely on such basic assumptions. Bond yields have been exceptionally low for years now, while high current stock valuations could mean lower returns in years to come. There’s also something known as sequence-of-returns risk—basically the chance that a harsh market slump during the early years of retirement could irreparably damage your income plan. When you have to start selling investments to draw down funds during a period of low returns, those shares can’t benefit when returns rise. This can derail portfolio growth just when you might need it most.
Charting a new course
Those possibilities also worry researcher Wade Pfau. Pfau, an economist and professor of retirement income at the American College in Bryn Mawr, Pa., has examined how the 4% rule would have fared in other countries’ financial markets. The result? Not so well—and he is concerned that today’s asset values mean that this strategy could fail for many retirees. “The 4% rule can’t be considered safe with interest rates as low as they are now,” Pfau says.
One alternative would be to use 3% for your initial withdrawal; that should work fine in most cases, according to Wade Pfau’s calculations. But many would-be retirees may find that painfully low. Rather than focusing narrowly on a flat withdrawal rate, Rob says, “you need to consider your investment portfolio and other factors as well—such as when you begin taking Social Security benefits, your life expectancy and how you balance your comfort with spending now versus the possibility of leaving money behind when you die.” It is helpful to start with a ballpark spending rate based on the 4% rule or—better yet—a personalized retirement plan. But the variables that go into the exercise are fundamentally uncertain—and they will change over time, he adds.
The search for financial stability
Many studies, including research from various academics as well as the Schwab Center for Financial Research, have also shown that including a low-cost annuity in your retirement plan could reduce the likelihood of exhausting your savings and boost your retirement income. That benefit comes from the bargain you make when you buy an annuity: You hand over a sum of money in return for the promise of income that can continue through your lifetime. That promise, of course, depends on the financial strength and claims-paying ability of the insurance company that issues the annuity—these products are not FDIC insured.
To be sure, annuities are complex instruments, but they can offer some advantages. The payments can be higher than what you’d receive if you’d invested the money yourself, because many people who buy annuities will die before they’ve recouped the value of their investments. And your risk of outliving your money ends as soon as your lifetime does. Before buying an annuity, it’s wise to consult your advisor to make sure the terms are the best possible fit for your needs.
And there are other approaches, too, that can help stretch your retirement income. You could divide your investments into segments according to when they’ll be needed, for example. Your taxable accounts, which you may draw upon early in retirement, might be invested more conservatively than, say, a tax-free Roth IRA, which you might tap much later or preserve for your heirs.
You can also build a floor of more predictable assets—Social Security, Treasury Inflation-Protected Securities (TIPS), and annuities, for example—that deliver enough income to cover basic expenses. Or, if you follow the 4% rule, you could cut back on spending after a tough year in the financial markets. You could also skip the next year’s inflation adjustment.
Researchers are always seeking the “efficient frontier” for retirement income: a point of balance that lets you spend as much as possible without compromising the integrity of your plan. These days, however, finding that balance requires flexibility in terms of your withdrawal rate. A static strategy can offer you a baseline, but being adaptable—to personal needs and market trends—is key.
What you can do next
Learn about creating a paycheck in retirement from ThomasPartners Investment Management®, offered through Schwab.