You work hard your entire life to build a nest egg that will eventually fund your retirement. Establishing, growing and securing your wealth hasn’t been easy - and it hasn’t been without sacrifice. But as you look toward the future, you have confidence that your lifetime commitment to work will pay off with a dream-fulfilling retirement.
If you are like most American pre-retirees, you plan to follow the 4% withdrawal rule developed by William Bengen back in 1998. Serving as an income distribution guideline, this rule says you can safely withdraw four percent of your portfolio in the first year of retirement and adjust that amount each year to account for inflation. Bengen believes that this model is sustainable for up to three-decades, enhancing its appeal to retirees who are fearful of outliving their money. Which, let’s face it, is every retiree.
Planning an effective - yet simple - withdrawal strategy for retirement is essential. Not only will it ensure an ongoing income stream, it will give you confidence to enjoy this well-deserved stage of life. As Albert Einstein so wisely said - “Everything should be made as simple as possible, but not simpler.”
Now that we’ve covered why an appropriate withdrawal strategy is important - let’s get back to Bengen’s 4% rule. And four reasons why it doesn’t work.
- It minimizes the importance of the sequence of returns: A successful retirement plan has built-in contingencies for things like market volatility and taxes owed on sold shares of capital gains. The sequence of returns essentially means that if you yield higher than average returns in the first decade of retirement, you will outpace the rate of your withdrawals and experience long-term success. On the other end of the spectrum, if you hit low or average returns early on you will likely run out of money - even if you follow the 4% rule to the T.
- It ignores market volatility (which is a thing): Even amatuer investors know market conditions play a role in the performance of their portfolio. The 4% rule says to increase your withdrawal amount from your investments each year, but it fails to address market volatility and the evolutionary nature of a portfolio’s balance. During a market downturn it would be wise to decrease your annual-cut, not take more. Retirees who blindly accept Bengen’s rule-of-thumb and ignore the markets will probably end up outliving their money.
- It isn’t flexible: The 4% rule is static, while retirement is dynamic. Your personal needs in retirement will change as you age, and so will your income needs. As a younger retiree, you are more likely to spend time traveling and exploring new hobbies. As you age, your travel budget will probably decrease while your medical expenses increase. Whether this holds true To the T - the point is your retired life will depend on an income distribution strategy that can adjust with you. The 4% rule is inherently inflexible and therefore counterintuitive for retirees.
- It follows a 30-year timeline: Some of us will retire late and others early. Some of us will live well into our 90s while others won’t make it past 70. We’ve addressed three other reasons why 4% withdrawal rule falls flat, but this last one is perhaps the most compelling. Bengen’s guidelines are based on a 30-year retirement - but what about those early or late retirees? What about those who live longer and those who pass away sooner? The inherent flaw in this rule is that it does not consider what happens to the individual who outlives the three-decade projection. By the time they are in a position to ask “what next,” their nest egg has been depleted and their static income distribution plan has been exhausted.
As you plan for retirement it is essential that you understand the withdrawal strategy you are expected to follow, and whether it will evolve with you through your post-career life. While the 4% rule may have worked for some people, it’s dangerous to label it a one-size-fits-all solution to retirement.