Twenty years ago Bill Bengen framed a complex question into an elegantly simple answer that remains relevant to the financial planning world and millions of retirees today, the so-called 4% rule.
The 4% rule is a guideline used to ensure a retiree's portfolio will last for the rest of their life. Bengen looked at actual historical returns dating back to the Great Depression. He examined numerous rates of withdrawal and the impact that devastating financial events had on portfolio longevity.
What retirees want to feel confident knowing is that if they experience Year 1 of retirement in a situation like the early Depression years, what is the likelihood of their portfolio lasting for another 30 years. But that wasn't the most detrimental time period in history. The worst was in 1973 - 1974. Not only did investors suffer through large declines in the stock market, they also lost purchasing power with inflation rates above 22%.
The best case scenario was that of a retiree who initially withdrew 4% of their portfolio in the first year of retirement. The rate each year was then adjusted by the rate of inflation. Bergen determined that throughout history, a properly invested portfolio that was continually rebalanced could sustain that so-called safe rate of withdrawal, lasting for 30 years, and in many cases, for 50 years or longer.
That rate of withdrawal is based on a number of important factors. First, it assumes that the investor has a properly diversified portfolio of stocks and bonds, and it is appropriately allocated - meaning it has the optimal percentage of stocks vs. bonds.
A properly diversified portfolio with more stocks than bonds had the greatest chance of success. Bengen specifically mentioned portfolios with between 50-75% in stocks. However, the ideal percentage will also depend on an individual client's comfort level with risk, spending patterns, as well as expected need of portfolio longevity, and whether or not they desire to leave assets to their heirs.
There are two cautions for retirees. First, note that retirees shouldn't increase their rate of withdrawal because of a few good years in the stock market. Those excess returns in early years may be needed to balance weaker returns later on. And, secondly, avoid the temptation of emotional investing. Panic in a market downturn may cause an investor to reduce or sell all of their stock investments to preserve what is left. That is precisely the wrong step to take and can be detrimental. Stocks have enormous recovery power and sticking with the right allocation is key to portfolio longevity and success.
Clients have another solution if they are caught in their first years of retirement in negative return territory. That is to change what they can control. Not by reducing the amount of stocks to preserve their portfolio nor by becoming overly aggressive and putting the portfolio at risk, but by reducing spending patterns, even if for a few short years. A small change in the level of withdrawals can have a dramatic compounding effect on the longevity of an investment portfolio.
It is intriguing that in those years Bengen examined, stock allocations below 50% in virtually every situation dating back to the Great Depression proved counterproductive in an effort to make the portfolio last throughout retirement. Now, that doesn't mean that no investor should have a conservative portfolio in retirement. Clients should expect their conservative portfolio may not keep pace with inflation and a safer withdrawal rate will likely be less than 4%. A lower rate of withdrawal will help ensure their portfolios aren't entirely consumed during their lifetime.
Conversely, as expected, historical portfolios that maintained an allocation close to 75% experienced a much more dramatic increase in wealth without sacrificing long-term portfolio sustainability - hence the suggested range proposed by Bengen of 50-75% equities.
The 4% rule fundamentally changed the financial planning profession since Bill Bengen's research was published some 20 years ago. It brought to light the importance of sequence of returns and long-term sustainable withdrawal rates, an important conversation as a retiree switches from paycheck to portfolio income. Every investor's situation is unique, and it is important to consider all personal and financial variables that may impact the portfolio. The 4% rule provides a good starting point to determine how much a retiree can safely withdraw without running out of money, but there are always other factors that need to be considered and addressed.
We are always delighted to assist clients with their retirement income plan. If you have questions about your retirement strategy and safe withdrawal rates based on your situation, please contact our office to schedule a phone call or meeting.