How much can you safely withdraw from your retirement savings each year without running out of money? This is one of the most important questions that retirees face, and one of the most popular answers is the 4% rule.
The 4% rule is a retirement withdrawal strategy that was published by advisor Bill Bengen in 1994. The 4% rule states that you can withdraw 4% of your portfolio value in the first year of retirement, and then adjust that amount for inflation every year. For example, if you have $1 million in your portfolio, you can withdraw $40,000 in the first year, and then increase that amount by the inflation rate every year.
The 4% rule has been widely adopted by many retirees and financial planners as a simple and reliable guideline. But does it still make sense in today’s economic environment? In this post, I will examine the assumptions behind the 4% rule, its strengths and weaknesses, and whether it still applies in light of current market conditions.
The Origins of the 4% Rule
Bengen created the rule by studying historical investment returns and inflation. He found that an investment portfolio of 50% stocks and 50% intermediate government bonds could sustain a 4% withdrawal rate for a minimum of 33 years. In most cases, the portfolio lasted for 50 years or more.
Bengen’s research was later confirmed by other studies, such as the Trinity Study by three professors from Trinity University in 1998. The Trinity Study extended Bengen’s data through 1995 and tested different asset allocations and withdrawal rates. The study found that a 4% withdrawal rate had a high probability of success for most portfolios over a 30-year period.
Mclean Asset Management updated Bengen’s data through 2010 and produced the following chart on maximum withdrawal rates depending on the year of retirement:
As you can see, the safe withdrawal rate has varied between 4-8% depending on the year someone retired. The 4% rule has held up even through the Great Depression, the high inflation of the 1970s, the tech bubble, and the 2008 financial crisis.
The Limitations of the 4% Rule
However, the 4% rule is not without its flaws. Here are some of the limitations that you should be aware of before applying it to your own situation:
- The rule is based on historical data, not future projections. It assumes that future market returns and inflation will be similar to those in the past. However, past performance is not a guarantee of future results. The market conditions that we face today may be very different from those in Bengen’s study period.
- The rule assumes a fixed asset allocation of 50% stocks and 50% bonds. It does not account for changes in risk tolerance, investment preferences, or market opportunities. It also does not consider fees, taxes, or other expenses that may affect your portfolio performance. Most importantly, it does not account for poor decisions by investors such as being too greedy near market tops or abandoning equities after market drops.
- The rule assumes a constant withdrawal rate that is adjusted for inflation. It does not account for changes in spending patterns, lifestyle choices, or unexpected expenses. It also does not consider other sources of income, such as pensions, annuities, or Social Security.
Morningstar Updates the 4% Rule
At the end of 2022, Morningstar updated its research paper The State of Retirement Income. Their paper analyzed historical data and came up with much lower withdrawal rates than Bengen. Here’s their analysis of the range of safe withdrawal rates through 2022:
Morningstar used Monte Carlo simulations on historical data, which means that their most negative scenarios were hypotheticals that did not come to pass. That led to safe withdrawal rates that are much lower than Bengen’s.
In 2021, Morningstar projected that the safe withdrawal rate for a retiree today was only 3.3%. After the sell-off in stocks and bonds that occurred in 2022, they updated their safe withdrawal rate projection to 3.8%. A big part of the increase in the safe withdrawal rate came through changes in their projected equity returns. The 2021 number assumed equity returns of 6-10.5% while the 2022 number assumes returns of 9-12%.
Morningstar gives a 90% chance of success to a retiree who withdraws 3.8% of their investments starting at the end of 2022. While 90% sounds like a high probability of success, I find it scary. Imagine going into a surgeon’s office for elective surgery and hearing there’s only a 90% chance of success. That means 1 in 10 surgeries fail! So not only is Morningstar advocating a lower withdrawal rate, but they are also only giving it a 90% chance of success.
Does that mean 4% is too high in this environment?
In recent years, Bill Bengen has updated his original rule based on newer data and revised the safe withdrawal rate higher! According to Bengen, based on new data and a slightly improved asset allocation (which includes equity allocations to small-cap stocks and international), a safe withdrawal rate historically is closer to 4.7-4.8%. Bengen found the assumptions used by the Morningstar research, particularly their equity projections released in 2021, far too pessimistic and conservative.
What I Think: Withdrawal Rate in Today’s Investing Climate
A safe withdrawal rate has 3 inputs:
- Equity Returns
- Fixed Income Returns
- Inflation Rates
There’s plenty of research indicating that high stock market valuations are correlated with lower future returns. That correlation is even stronger with inflation-adjusted real returns (which is the most important factor for this analysis). So, a low starting valuation supports higher withdrawal rates while a high valuation would suggest a lower withdrawal rate is appropriate.
The blue line in the following chart from Robert Shiller shows the valuation of the stock market based on the cyclically adjusted price-earnings ratio (CAPE). At a current level of over 30, the US stock market trades for one of the most expensive valuation levels in history.
The red line in the chart above shows long-term interest rates. With current rates just over 4%, we’re trading near historic averages on interest rates.
So with valuations at extreme highs and interest rates trading around average levels, where should a new retiree set his withdrawal rate? I believe the original 4% rule is still king. Remember, 4% has kept a retiree safe in every historical environment thus far. That included a retiree who started in 1929 and saw equities drop nearly 90%!
Bengen is also very bearish on the stock market given current valuation levels. In an interview with Morningstar at the end of 2021 he said he only had ~20% of his personal portfolio in equities. Even with his pessimistic outlook for stocks, he suggested a safe withdrawal rate today is likely only around 20 basis points lower than the historical safe 4.7-4.8% rate. Thus he might consider a withdrawal rate as high as 4.5-4.6% appropriate even with sky-high valuations.
I think the 4% rule is still a great rule of thumb for most retirees in today’s climate. I do find equity valuations particularly concerning, but an investor who avoids bad investing behavior (i.e. bailing out after a large drawdown) will still have a high likelihood of having their money last 30 years.
Many out there advocate for a more flexible approach, i.e. decreasing spending when equities have done poorly or increasing it when the market has done well. While that sounds great in theory, I think it has shortfalls in practice. It’s much harder to decrease your spending once you’ve gotten used to a certain lifestyle. Indeed, many costs become fixed as we take on mortgage and housing payments. It’s much easier to start retirement off conservatively and find out that you can spend more. Who doesn’t want to hear they can take more trips and spend more money?!
Thus I think most retirees should set an initial withdrawal rate of 4% or less. If their returns exceed expectations they can then adjust their withdrawal rate higher in the future if appropriate.
If you’d like to discuss your retirement plans or withdrawal rate, reach out and set up a free consultation today. Thanks,
Scott Caufield, CFA, CPA