Popular retirement income strategy 4% rule may be outdated

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Market conditions are putting pressure on the 4% rule, which is a popular rule of thumb for retirees to determine how much money they can live on each year without worrying about using it up later.

Withdrawing funds from a person’s nest egg is one of the most complicated financial activities of a family. There are many unknowns-retirement time, one’s expenditure needs (such as medical expenses) and return on investment, to name a few.

The 4% rule is designed to generate a stable annual income stream and give seniors a high level of confidence that their funds will continue to retire for more than 30 years.

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Simply put, the rule stipulates that retirees can withdraw 4% of the total value of their portfolio in the first year of retirement. The dollar amount increases with the inflation (cost of living) in the following year, and will increase in the following year, and so on.

However, market conditions—that is, lower expected returns on stocks and bonds—seem to be detrimental to retirees.

According to a paper published by Morningstar researchers on Thursday, given market expectations, the 4% rule “may no longer be feasible” for the elderly. They say that today, the 4% rule should actually be the 3.3% rule.

Although the reduction sounds small, it may have a big impact on the living standards of retirees.

For example, using the 4% rule, an investor can withdraw $40,000 from a $1 million portfolio in the first year of retirement. However, using the 3% rule, the withdrawal amount for the first year drops to $33,000.

According to CNBC’s analysis, taking into account inflation, this difference will become more pronounced after retirement: $75,399 and $62,205 in the 30th year. (The analysis assumes an annual inflation rate of 2.21%, which is the average level that Morningstar predicts for the next three years.)

Why is it 3.3%?

Christine Benz, head of personal finance and retirement planning at Morningstar and co-author of the new report, said that in the past few decades, retirees have enjoyed a “three consecutive championships” of positive market development.

She said low inflation, low bond yields (which have boosted bond prices) and strong stock returns help boost investment portfolios and safe withdrawal rates.

Mercedes-Benz said this dynamic may give people close to retirement a false sense of security.

According to the report, bonds are “very unlikely to achieve strong returns in the next 30 years”, and high stock prices may fall as they return to average levels. The analysis admits that this result may, though not be inevitable.

(Although the inflation rate has been at historically high levels in recent months, Morningstar expects it to ease in the long term.)

Due to the so-called return sequence risk, investment returns are particularly important in the early stages of retirement. Withdrawing too much money from a person’s nest egg in the first or several years—especially from a portfolio of investments whose value is declining at the same time—will greatly increase the risk of capital exhaustion in the future.

This is because once investment rebounds, there will be less room for growth in the portfolio.


Of course, there are many caveats to this analysis of the 4% rule.

On the one hand, the 4% rule (and the newer 3.3% rule) only considers one person’s portfolio. It does not consider non-portfolio income sources such as social security or pensions.

For example, retirees who delay in applying for Social Security until the age of 70 will get a higher monthly income guarantee and may not need to rely too much on their investment.

In addition, the rule of thumb uses conservative assumptions. For example, it uses a 90% probability that the elderly will not run out of money after 30 years of retirement.

Retirees who are satisfied with higher risks (that is, with a lower probability of success) or believe that they will not live to be 90 years old may be able to safely withdraw more funds each year. (A 65-year-old person today can live another 20 years on average.)

Perhaps most importantly, the rule assumes that one’s expenditures will not be adjusted according to market conditions. But this may not be a fair assumption—research shows that senior citizens’ spending during retirement usually fluctuates.

According to Morningstar, retirees have some options in this regard to ensure that their investments are effective in the long term. Usually, these requirements reduce withdrawals after years of negative returns on the portfolio.

For example, retirees can abandon inflation adjustments during those years; they can also choose to reduce their typical withdrawals by 10% and return to normal when the return on investment becomes positive again.

“You can make some simple adjustments,” Benz said. “It doesn’t have to be a huge strategy; it can be a series of incremental adjustments that can have an impact.”

However, there are trade-offs to be flexible. Mainly, making these annual adjustments to expenditures may mean that a person’s living standards fluctuate drastically from year to year.

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