It began with the forging of the Great Rules. Three percent annual returns were given to treasury-bills, immortal, fairest, and surest of all investments. Five percent was given to bonds, disciplined and reliable sources of revenue. And seven, seven percent was given to company stocks, which above all else desire capital return. For within these rules were bound the benchmarks to govern any retirement portfolio. But they were all of them relieved, for another rule was made. Deep in the land of California, under the blistering sun of San Diego, the great financial planner William Bengen forged a master rule in secret, and into this rule he poured all of his foresight, his experience, and his will to encompass any retirement scenario. One rule to ring them all.
What I am discussing, for those who don’t fantasize about Lord of the Rings featuring a plucky band of accountants, is the “four percent rule.” I hope to cover what it is, the reasoning behind it, and its validity in current market conditions. And no orcs, I promise.
Planning for income needs in retirement is difficult under the best of circumstances. On the one hand is a retiree with a large balance in their retirement account, saved up over a lifetime of hard work. On the other is an unforeseeable number of years of living expenses, with unpredictable market returns and unknowable inflation.
Faced with this conundrum, William Bengen researched the historical record to determine not which plan could work, but which one always works. His study, published in 1994, found that a four percent withdrawal rate provided a minimum of 30 years of retirement income. This proved true across many financial crises, from the Great Depression to the stagflation of the seventies. He experimented with a variety of allocations and his insights were far-ranging, but for retirees the take-away was this: the most you can withdraw from your portfolio with (almost) total peace of mind is four percent.
It’s important to note a few things. First, the withdrawal amount was increased each year for inflation, but otherwise stayed constant through good and bad markets. It’s tempting to “dip into the pot” during years with great returns, but extra assets were often the only cushion against bad years. Second, Mr. Bengen assumed 25 to 30 years spent in retirement. He acknowledged that those with longer life expectancies or early retirements might have to lower their expectations. And third, he used a 50/50 split of stocks and treasuries as his baseline, rebalancing the account year after year.
Twenty years later, there are many who argue that Bengen’s rule no longer holds water, or at least must be amended. Because of low interest rates, the same50/50 ortfolio used in the study will no longer grow at the same rate it did in the nineties. People are living longer, and their care in old age is becoming more and more expensive. Others argue in the opposite direction, saying it’s silly for a spry and energetic 65-year old to penny-pinch when, after a few decades, they might become homebound or even pass away.
Some of these criticisms are more valid than others, but collectively they probably only lower the four percent rule from a virtual guarantee to a very reliable benchmark. Most of them are addressed in the original study. Low returns are problematic for any portfolio, but high inflation is far more dangerous, and current inflation rates are well below historic norms. Greater life expectancy can certainly lead to asset depletion, but almost every projection year in the original study remained solvent well past 40 years of retirement, especially if it had higher stock allocations. And Mr. Bengen acknowledges that retirees certainly can withdraw at a higher rate, but they need to be aware of the risks, and take into account whether their guaranteed income (social security, pensions, and annuities) is enough to live on if their portfolio runs out.
Like anything else in financial planning, then, the “four percent rule” should be viewed as one tool out of many. For those who favor security and certainty, it can be used to plan a sustainable withdrawal rate. Those who favor more growth-oriented returns and adjust their withdrawals upwards can use it as a yardstick to determine how much risk they are taking on.
Of course, once you add in Social Security filing strategies, pensions, mortgage debt, and inheritance planning, the retirement can become increasingly muddled and complex. If that seems overwhelming, feel free to come in and see one of our advisors at Winch Financial. Just don’t ask them to recite the Fall of Gil-Galad. They tend to scowl when you do that.