With interest rates stuck at all-time lows, inflation surging, and stock markets at all-time highs, there are many in the financial services industry who are questioning the wisdom of the 4% withdrawal rule for retirement.
As a quick reminder, the 4% rule basically says that if you withdraw 4% of your portfolio value in your first year of retirement, and you adjust that amount each year for the actual inflation rate you experience, the odds are over 95% that the money will last for a typical 30-year retirement. But now, many are questioning whether it still works.
The financial research firm Morningstar recently published a report indicating the new “safe” withdrawal rate might only be 3.3%. What’s causing the rethinking of the rule? It all comes down to projections for future returns and inflation. Let’s take a look at a few numbers to help illustrate the issues.
Let’s assume you retire with $1 million and want to withdraw $40,000 of that money your first year of retirement (4%). Now let’s assume there is no inflation going forward, so you don’t have to increase your withdrawal to maintain the same standard of living. In this example, the money will last 25 years. While that’s fairly close to 30 years, it doesn’t get you all the way. If you want your money to last 30 years, it has to grow. But by how much?
If there is no inflation and your money grows at 1.5% a year, then on paper it will last 30 years. Your principal would be almost gone, but the portfolio does technically last 30 years. This gives you a bottom-line benchmark for portfolio survival. Basically, your returns must outpace inflation by at least 1.5% a year if you want a high likelihood of having your money last 30 years. In this example, inflation was 0%, so all you needed was a 1.5% portfolio return.
This doesn’t seem too hard until you realize that today inflation is running over 5% and bond returns are about 2%. Thus, you cannot simply invest in bonds or CDs and expect to make it. But what about stocks? Surely, they can provide the extra return. If we look at the last decade, it seems like that should be pretty easy, as U.S. stocks have averaged about 16% a year.
But the long-term return for stocks is more like 10%. And many feel that since we’ve just had a decade with above average returns, we are likely to face future cycles of below average returns. Some strategists expect stock market returns to be much lower going forward, maybe in the 6% range.
If stocks return 6% and bonds 2%, then in a blended 50% stock and 50% bond portfolio, your return would be 4%, which is equal to your distribution rate of 4%. But if inflation runs 3% a year, it will drive your annual distribution rate above your portfolio returns, and you’d run out of money just before the end of 30 years. That’s why some are suggesting a lower distribution rate to build in a margin of safety.
The problem with all of this scenario planning is that over the next 30 years no one has any idea what the returns will be for stocks, bonds and inflation. Heck, the Federal Reserve, with its thousands of Ph.D. economists, couldn’t even predict inflation for this year.
Investors and economists are notoriously poor at predicting future returns. There are so many variables that predictions can easily be rendered useless. For instance, Jeremy Grantham, who is a well-respected investor and market strategist, publishes a forecast for future stock market returns each year.
He famously predicted the bubbles in 2000 and 2008, so investors tend to pay attention to what he has to say. But in this current market cycle, he has been wildly wrong. In 2014, he predicted inflation-adjusted returns in U.S. stocks for the next seven years would be negative. But since the beginning of 2014, stocks have averaged over 14%, not even close to his prediction.
While I agree that the 4% withdrawal rate is not as certain as it was before, I think it is still a rational basis for retirement planning. It’s more likely than not that 4% will still work. But you have to use some common sense. If markets tank, it’s a good idea to reduce your distributions until the market recovers. Reducing by just 1% can make a big difference. That’s why it’s important to retire with as few debts and fixed expenses as possible. This is the most important thing you can do to raise your odds of living off your money. It gives you the flexibility to adjust if needed.
Charlie Farrell is a partner, managing director at Beacon Pointe Advisors LLC. The information contained in this article is for general informational purposes only. Opinions referenced are as of the publication date and may be modified because of changes in the market or economic conditions and may not necessarily come to pass. All investments involve risks, including the loss of principal.