The 4 Percent Rule: Limitations and Alternatives

Although the 4 percent rule remains a reliable benchmark, many experts are questioning its efficacy as economic conditions evolve. RossHelen/Shutterstock

The 4 percent rule has been the rule for retirement spending for decades. According to David Blanchett, managing director and head of retirement research at PGIM DC Solutions, 61 percent of financial advisors use the 4 percent withdrawal rule.

According to this rule, retirees should withdraw 4 percent of their savings each year, adjusted for inflation, and should not run out of money in 30 years. Developed in the 1990s, this idea has saved the lives of many retirees planning their golden years. Although the 4 percent rule remains a reliable benchmark, many experts are questioning its efficacy as economic conditions evolve.

The Origins of the 4 Percent Rule

Let’s rewind a bit. According to William Bengen, who analyzed historical market data on stock and bond returns over the 50 years between 1926 and 1976, the 4 percent withdrawal rate is safe.

According to his research, he assumed a portfolio split between stocks and bonds under various market conditions. Even during tough economic times like the Great Depression, 4 percent emerged as a “safe” withdrawal rate.

Why the 4 Percent Rule Might Need to Be Retired

Let’s face it: Times have changed. And that 4 percent rule might be starting to feel outdated.

• Bonds are boring (and broke). In Bengen’s day, bonds were the steady Eddies of the investment world. After all, they offered decent returns to cushion the blow of a dip in the stock market. Those days are over. Currently, interest rates are hovering around historic lows, so your bond yields are unlikely to fund a luxurious lifestyle.
• The market? More like a roller coaster. Volatility has become the new norm. Seriously, it’s enough to make your head spin. When you are withdrawing money, those early market downturns can be really painful. In finance, it’s called a “sequence-of-returns risk,” which can ruin your retirement.
• We’re living longer, but that comes with a price tag. Thanks to medical advances, we’re all living longer than ever. However, it also means that our retirement nest eggs must last longer. That 30-year horizon Bengen used? For some of us, this might be too optimistic.
• Healthcare costs? Out of control. In recent years, medical expenses have skyrocketed. This wasn’t a significant factor in the early days of the 4 percent rule. Even the most carefully planned retirement can be seriously derailed by it.

Considering all these factors, the 4 percent rule is starting to seem a bit less… rule-like. Now, it’s more of a guideline, a starting point for a deeper discussion.

Alternatives to the 4 Percent Rule

So, what’s a retiree to do? Thankfully, plenty of alternatives to the 4 percent rule offer more flexibility, personalization, and peace of mind.

Dynamic Withdrawal Strategies

Think of a retirement plan that adjusts to market fluctuations. This is the beauty of dynamic withdrawal strategies.

• Percentage of portfolio. You withdraw a percentage of your portfolio each year instead of a fixed dollar amount. The percentage could range from 3 to 5 percent, allowing your spending to fluctuate with your investments. When the market is up, you can spend a little more; when it dips, you tighten your purse strings.
• Guardrails. You can think of this as setting spending boundaries. You set upper and lower limits. In case of a boom in your portfolio, you may be able to increase withdrawals (within the upper guardrail). During a market downturn, you reduce them to stay within the lower limit. As a result, there is a safety net while still allowing some flexibility.

In order to succeed with dynamic approaches, you need a little discipline and regular check-ups. They are, however, much more resilient than rigid rules like the 4 percent rule.

The Bucket Strategy

Have you heard of the bucket strategy? It involves organizing your retirement savings into compartments.

• Short-term bucket. This is your emergency fund. As such, it should have cash or cash equivalents to cover 1–3 years of living expenses. By doing this, you won’t need to sell investments during market downturns.
• Medium-term bucket. There are 3–10 years’ worth of expenses in this bucket. The money is invested more aggressively, perhaps in bonds or other investments with moderate growth potential.
• Long-term bucket. In this bucket, stocks are invested to outpace inflation over time.

This strategy takes care of your immediate needs while your long-term investments grow. While your long-term investments recover, your safer buckets can also help mitigate the risk of a market crash early in retirement.

The Bogleheads’ Variable Percentage Withdrawal (VPW) Strategy

Bogleheads, an investment community known for personalized investments, champions this model.

• Age, allocation, and balance. The VPW strategy considers your age, asset allocation (stocks or bonds), and current portfolio balance to determine your appropriate withdrawal rate.
• Chart-based approach. Retirees consult a chart created for the VPW strategy to make withdrawal decisions.

In general, this strategy is designed to adapt to market returns, making it less likely you will outlive your savings. Despite this, you will likely find your spending fluctuating along with the market, which can be unsettling.

The Yale Spending Rule: A Blend of Stability and Flexibility

This rule, inspired by Yale’s endowment, balances the need for consistent income with the preservation of fund value.

Two-pronged approach:

• Adjusted for inflation, 70 percent of the previous year’s distribution. As a result, you receive a steady income adjusted for inflation.
• An average fund balance of 30 percent multiplied by a fixed spending rate of 5 percent over the past three years. You can adjust your spending based on the performance of the market with this component.

With the 70/30 split, you can adjust it according to your risk tolerance and desired level of income stability.

The Dividend Spending Rule

With the dividend spending rule, retirees can leave a legacy while preserving principal assets for future generations.

This strategy was developed by James Garland, former president of The Jeffrey Company. Based on his research, he discovered that withdrawing 130 percent of investment dividends allows you to maintain inflation-adjusted principal growth while generating a sustainable income.

With dividend-based withdrawals, spending is tied to dividends rather than portfolio value, reducing volatility. Additionally, the principal can grow or remain stable by capping withdrawals, making it ideal for those concerned about leaving an inheritance.

Maximizing Social Security Benefits

You can start claiming benefits at age 62. However, you should take your benefits later, such as at age 70. Although it may seem reasonable to begin receiving benefits as soon as possible, delaying claiming will increase your monthly payments. Each year you wait to take Social Security after you reach full retirement age, your benefits increase by 8 percent.

In short, delaying benefits makes sense if you expect to live longer or want to maximize your guaranteed income.

Annuities

The main benefits of annuities are their reliability and the fact that they address two of the significant risks of retirement;

• Longevity risk. This refers to the fear of outliving your savings.
• Sequence-of-returns risk. Early market downturns may deplete your portfolio.

With lower costs and commission-free options, modern annuities are more consumer-friendly. In addition to providing peace of mind, they come with trade-offs such as reduced liquidity and fees. When considering annuities, retirees should carefully evaluate their objectives.

Adjusting Asset Allocation

According to the 4 percent Rule, stocks and bonds should be allocated in a balanced way. However, increasing equity exposure to 75 percent can improve portfolio longevity and growth, especially as people age. Although stocks are more volatile, they may provide better long-term returns.

Strategizing Required Minimum Distributions (RMDs)

The IRS requires retirees to take minimum withdrawals from tax-deferred accounts after they turn 73. In contrast to the 4 percent Rule, RMDs are calculated based on account balances and life expectancy every year. For some retirees, this makes them a more realistic option. To continue growing your wealth, you can reinvest your RMDs if you don’t need the income.

The Bottom Line

Although the 4 percent Rule is a good starting point, it isn’t a one-size-fits-all solution. Considering your unique circumstances and exploring these alternative strategies can help you create a retirement plan that ensures your income and security.

Remember, retirement planning is an ongoing journey. To ensure you’re on track toward your financial goals, review your plan regularly and make adjustments as needed.

By John Rampton

The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.