Is it time to retire the 4% rule?
Short-cuts have their place. If you can avoid complexity and effort, it makes absolute sense to do so. It gives you time to work on other projects, or in my case re-watch The Treble (1999), reliving the good ol’ days. However, when it comes to retirement income, short cuts may be counter-productive and nowhere is this more apparent than with the 4% rule.
Even since it was ‘discovered’ by aeronautical engineer turned financial adviser William ‘Bill’ Bengen in the early 1990s, 4% has been the generally-accepted rule for how much can be withdrawn from a pension pot without a) running out of money, or b) leaving too much behind for greedy relatives to fight over.
The problem is that it was built for a different time. A time when bond yields were higher and quantitative easing was an obscure concept confined to economic textbooks. Our research shows the lucky retiree who began drawing down in 1993 using the 4% rule had seen their capital gain 46% in real value by 2008, while retirees who start between 1998 and 2001 are far less fortunate. They’ve had to navigate the bursting of the technology bubble and the global financial crisis, the combination of which has left a 41% dent in their starting capital.
While 4% drawdown seemed over-cautious for the 1993 intake, it looks reckless for later generations. That 41% drop in capital means that for an 80-year old woman buying an annuity, after 15 years withdrawing at 4%, her future income has dropped dramatically too (particularly given the decline in bond yields and therefore annuity rates).
What’s the alternative? It would be tempting to try and invent another rule of thumb – 2.5%, for example. However, that is also inflexible and doesn’t recognise that bond yields may rise again in future, or that the stock market may power up. We could also prescribe retiring at the start of a bull market – that has worked extremely well for investors – but it is largely impossible to do in practice.
To our minds, there are three solutions needed for the problem: managing overall costs, broader diversification and adjusting income flexibly from year to year. After all, Bengen didn’t capture fees appropriately. Secondly, he assumed a rather non-diversified portfolio of just US equities and US bonds. Spreading investments over different asset classes gives investors a better chance of preserving capital. Finally, flexible income withdrawal is particularly important. This allows for adjustment to the market cycle, to individual retiree needs and changes in circumstances.
Retirement income strategy
Each investor’s situation differs along with their appetite for risk, their retirement spending goals or portfolio capital. Following the ‘short-cut’ 4% withdrawal strategy blindly may lead to particularly volatile results. Indeed Bengen’s research did not suggest withdrawing this amount every year – just that it was safe to do so without running out of money. A dynamic withdrawal strategy, more closely linked to the amount of spending necessary per year rather than a fixed portfolio percentage, may significantly improve the investment outcomes. Indeed, maybe it is time to retire the 4% rule itself…
For more detailed analysis on the 4% rule, please see our recent article.