How much can retirees safely withdraw from their investment portfolio each year?
The “4% rule” is a well-known concept among financial advisers, originating from research published in the Journal of Financial Planning in 1994. According to this research, a 65-year-old couple could withdraw 4% of their savings at retirement and adjust this amount for inflation over 30 years. If 4% of your retirement savings can cover one year’s expenses, there is a high likelihood (over 95%) of having enough money to last throughout a 30+ year retirement. However, it’s important to note that these are probabilities based on historical data, not guaranteed future outcomes.
The 4% rule was developed taking economic downturns into account, and it has generally held up well during recent financial crises.
So, is the 4% rule failproof?
Unfortunately, there’s no such thing as a completely safe withdrawal rate. There has been one instance where the 4% rule didn’t hold up. Using the 4% initial withdrawal rate, the 1969–2000 period would have exhausted a portfolio. The ‘70s began with a devastating bear market that lasted until 1982, and the damage done in the first 12 years was irreversible.
Yes, but…
While investment returns and inflation are always uncertain, no one sets up 4% distributions and then ignores what happens to the portfolio. A 75% probability of success is an acceptable projection when an adviser is monitoring the portfolio regularly. Minor adjustments can usually be made long before the portfolio is at risk of depletion, increasing the likelihood of success.
With this flexibility in mind, it may be possible to take portfolio withdrawals of more than 4%. Many retirees receive other sources of income, like pension benefits and Social Security, which provide guaranteed monthly income. Should the guaranteed income sources cover all or most fixed expenses, the portfolio withdrawals could be greater, knowing temporary cutbacks may be prudent during bad markets.
Breaking the 4% rule
Strict adherence to the 4% rule doesn’t factor in changing needs and circumstances. The research referenced above assumes no spending changes throughout retirement. In reality, spending is usually greater at the beginning of retirement and declines as we age.
By considering discretionary spending, retirees may increase their income. For instance, a withdrawal rate closer to 5% may be sustainable during good years if the retiree can reduce withdrawals in bad markets. This seemingly minor adjustment from 4% to 5% represents a 25% increase in potential portfolio income. It’s a strategy that could provide additional income for retirees to enjoy when they’re more likely to be active.
We often counsel retirees not to withdraw more than 6% of their principal in one year. By regularly monitoring the withdrawal rate, small reductions in spending can go a long way to assuring that your principal stays intact in the long run. This concept was studied using a rules-based spending approach, and the results were published in 2006. The study found that 5.2–5.6% withdrawal rates are sustainable in a portfolio containing 65% equities with 99% confidence—provided rules are implemented to adjust withdrawals when needed.
Keeping the market in mind
The proper withdrawal rate is all about finding balance. We believe the 4% withdrawal rate is still prudent guidance when projecting retirement income from a balanced portfolio. A balanced portfolio mix of stocks and fixed income can help manage risk and potentially increase returns. Of course, adjustments will likely be needed along the way.
We monitor our clients’ withdrawals to avoid a distribution rate that exceeds 6% of the portfolio value in down markets. This means that a portfolio would need to lose a third of its value before withdrawals should be reduced. Once the portfolio value recovers, the original withdrawal amount can be quickly restored.
No one knows what the future holds for the stock market. The best defense is to have control of your spending. That way, you can quickly cut back in a down market, if necessary. We can learn some valuable lessons from the 1969 retiree scenario. Allowing the annual withdrawal rate to get too high due to inflation caused too much principal to disappear before the great bull market of the ‘80s got underway.
In conclusion, we feel the 4% rule is a reliable guide for now. The key to a successful retirement is to remain disciplined in managing withdrawal rates, particularly in down markets, and to practice prudent spending when necessary. It’s important to postpone big expenditures until the money has already been earned during a good market. By sticking to your investment strategy and avoiding investment fads, you can stay focused on your long-term financial goals.
Insights:
- The 4% rule was developed as a safe withdrawal rate considering worst-case economic scenarios.
- Strictly following the 4% rule doesn’t account for spending flexibility.
- 5.2–5.6% withdrawal rates may be sustainable when the retiree has flexibility to reduce distributions during bad market conditions.
