The Four Percent Rule Revisited
Episode 156 – The 4% Rule has been one of the standard models of retirement planning since the 1990s. The rule, however, has come under attack of late. A recent report by Morningstar indicates that the real number is more like 3.3%. What’s a retiree to do?
Transcript of Podcast Episode 156
Hello this is Bill Rainaldi, with another edition of Security Mutual’s SML Planning Minute. In today’s episode, the Four Percent Rule revisited.
We discussed the Four Percent Rule all the way back in episode 17. The Four Percent Rule is a a rule of thumb for how much retirees can safely withdraw from their savings each year without fear of outliving their money. The most common variation of the rule suggests that you spend no more than 4 percent of savings in the first year of retirement. You would then adjust that amount annually to keep pace with inflation. The Four Percent Rule has been one of the standard models of retirement planning since the 1990s.
A recent analysis from Morningstar, the investment research giant, has poked a few holes in this long-held assumption. In their new report, “The State of Retirement Income: Safe Withdrawal Rates,” Morningstar concludes that four percent is just too aggressive. The real number, they say, is more like 3.3 percent.
This is bad news for upcoming retirees. Morningstar assumes a 30-year retirement period. Under their analysis, if you use 4 percent, you may eventually run out of money while still in retirement.
Digging into the numbers, Morningstar’s main culprit is current values in the financial markets. The Four Percent rule is based on an assumed portfolio of 50 percent stocks and 50 percent bonds. In past years, this would have allowed 90 percent of people to have their portfolio last more than 30 years.
But the people at Morningstar see things differently today. They point out that the average price to earnings ratio for the S&P 500 over the last twenty years has been 17.35. Today it is 23.88. In other words, stocks are more expensive than they used to be, and the expected returns are thus lower. As Christine Benz from Morningstar puts it, “It’s counterintuitive, but when the stock market and stock valuations are high, it’s the worst time to retire.”
Inflation plays a role in all this as well. It is currently at a 30 year high. If that continues, even 3.3 percent may be unrealistic.
There is one aspect, though, that the Morningstar research didn’t address: how active or inactive you are in retirement. Some people tend to spend more money in the early (active) years of retirement than in their later (passive) years of retirement. Travel and other activities tend to occur more often in those early years. Thus, some people tend to spend more, say, in their sixties than they do in their eighties, when health issues may prevent a more active lifestyle. Of course, health care expenses in the later years can also change the equation.
What can a typical future retiree do about this? Morningstar has a couple of suggestions. Their first suggestion is simply to work longer. The longer you work, the shorter your retirement will be, and the less time your portfolio will need to last. This is certainly true, but likely to be seen as an undesirable alternative by many investors.
Morningstar’s second alternative is similar: delay collecting your Social Security for as long as possible. The longer you wait—up until age 70—the more money you’ll collect each month, and thus the less of a burden your portfolio has to carry.
Another suggested alternative would be putting a limit on the Four Percent Rule. You can withdraw the full 4 percent the first year but forgo inflation adjustments in any year after which your portfolio incurs losses. The problem with this, of course, is that over time it erodes the retiree’s standard of living. That by itself may discourage many people. A whole life insurance policy could go a long way in solving the Four Percent problem.
Surprisingly, taxes are one key area to which the Morningstar report gives little attention. There are key differences between a tax-deferred retirement portfolio, a regular taxable portfolio, a Roth IRA and a potentially tax-free source of income, such as a capitalized whole life insurance policy.
The Morningstar report does very little to address these differences, but over a long timeframe, they can spell the difference between success and failure. Contact your Security Mutual Life Insurance Advisor today to learn more.
Sources
Benz, Christine and Rekenthaler John. “What’s a Safe Retirement Spending Rate for Decades Ahead?” Morningstar.com. https://www.morningstar.com/articles/1066569/whats-a-safe-retirement-spending-rate-for-the-decades-ahead
Wooleley Suzanne. “Morningstar Says The 4% Rule is Now 3.3%.” FinancialAdvisor.com. https://www.fa-mag.com/news/prepare-to-live-on–33-000-a-year-if-you-retire-with-a–1-million-portfolio-64906.html?section=303&utm_source=FA+Subscribers&utm_campaign=719d187b93-FAN_AM_Send_052220_A-B+Split_COPY_01&utm_medium=email&utm_term=0_6bebc79291-719d187b93-222644277
Tergesen, Anne. “The 4% Retirement Rule Is In Doubt. Will Your Nest Egg Last?” WSJ.com. https://www.wsj.com/articles/the-4-retirement-rule-is-in-doubt-will-your-nest-egg-last-11636713035
Mangian, Selena. “7 Reasons to Retire Early, and 7 Reaons Not To.” TheMotleyFool.com https://www.fool.com/retirement/2020/04/10/7-reasons-to-retire-early-and-7-reasons-not-to.aspx
This podcast is brought to you by Security Mutual Life Insurance Company of New York…The Company That Cares®, and is designed to provide general information regarding the subject matter covered. The content is believed to be current as of the date of the publication; however, Security Mutual makes no representations, warranties or guarantees, whether express or implied, that the content provided is accurate or complete.