Generations of financial planners have advised their clients to use the 4% rule when planning retirement withdrawals. But is it still relevant today?
This article explains that, while the 4% rule can be a good way to think about how much you will need to save for retirement, it can never replace a proper financial plan.
Like most rules of thumb it’s not completely worthless – but it’s also not the answer to a happy and prosperous retirement. Planning your retirement is probably the biggest financial decision you’ll ever have to make so please do consult a qualified financial planner.
If you’ve never heard of the 4% rule, now would be a good time to acquaint yourself with it. The rule of thumb states that:
If you withdraw 4% from your retirement portfolio annually (adjusted for inflation), your savings will last for 30 years. (Assuming that you’ve invested in a balanced portfolio, comprised of 50% of equity and 50% of interest-bearing investments.)
First, some history
An American financial planner, Bill Bengen, invented the rule in the 1990s. He arrived at the 4% figure by considering various withdrawal strategies through various historical scenarios, including economic crashes. He then identified the withdrawal rate that would have succeeded in the one worst scenario in history.
These days, the 4% rule has fallen out of favour somewhat. Critics say the one-size-fits-all approach cannot account for a multitude of many moving parts. Time horizons vary from investor to investor, and other factors like interest rates, market returns, inflation rates and fund management fees are constantly fluctuating. Put bluntly, it’s hard to use a rule of thumb to understand retirement planning – a field Nobel Prize-winning economist William Sharpe has described as “the nastiest, hardest problem in finance.”
Beware of portfolio volatility
What is known as the “early sequence of returns” is the greatest risk to a retirement plan based purely on the 4% rule. In layman’s terms, this means that suffering negative returns early in your retirement is far more detrimental to your portfolio than suffering the same negative returns at a later stage.
This is why, income-producing portfolios such as living annuities are much more sensitive to portfolio volatility than other capital. Modelling done by Ninety One showed that when investment returns and income drawdowns were kept exactly the same, increasing the portfolio volatility from 9 to 15% would raise the risk of a living annuity failing over 30 years by almost 300%.
So…Does the 4% rule still have a place?
The 4% rule is far from perfect, but we do still think it acts as a useful guideline to help people understand the relationship between retirement capital and income. And it definitely comes in handy when making investment decisions in a complex and dynamic environment.
The 4% rule of thumb can also help you to determine the amount of capital you need for retirement. For instance, if you want to earn R 50 000 per month in today’s terms, you can use the 4% rule to work out that you’ll need a lump sum of R 12.5 million when you retire. (All figures are pre-tax.)
But, as the Ninety One research shows, there’s far more to prudent retirement planning than sticking to the 4% rule of thumb and maintaining a balanced portfolio. It’s imperative that you regularly review the asset allocation of your retirement portfolio and keep both volatility and the drawdown rate in check. Given the current volatility in the markets, it might be a good idea to reduce your drawdown rate for the foreseeable future. I definitely wouldn’t be increasing my income by inflation in the current climate.
That said, despite the turbulent markets and the grim immediate outlook, it is still essential to maintain a substantial equity component in a retirement portfolio. This is not the time to bail out of equity as doing so would lock in an irredeemable loss to your retirement portfolio. Research has shown that for a 4% drawdown rate to work, you need to have at least 60 % invested in equity.
The final word
The 4% rule can be a good way to think about how much you will need to save for retirement, but it can never replace a proper financial plan. Planning your retirement is probably the biggest financial decision you’ll ever have to make so please do consult a qualified financial planner. Only a professional can come up with a plan that takes all the variables into account and is also uniquely tailored for your (and your family’s) situation.
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Disclaimer – The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.