For a long time, the 4% rule was one of the most trusted pieces of financial advice. The idea was that if you wanted to retire and maintain your lifestyle without running out of money, you should withdraw no more than 4% of your retirement savings each year. But with the recent market turmoil, changes to interest rates, and rising inflation, is this still true? Here is why it may no longer be.
The 4% rule explained
The 4% rule was first coined in 1994 by financial advisors William Bengen. According to his research, withdrawing no more than 4% of your retirement savings each year would give you enough money for 30 years of retirement without running out of funds. That means if you have $1 million saved for retirement, you could withdraw $40,000 a year and not worry about depleting your nest egg.
What has changed?
In the 30 years since the 4% rule was introduced, there have been some major changes that make it less reliable today. One big factor is inflation. The average U.S. inflation rate since 1913 has been 3.1%. With inflation hitting as high as 9.1% this past summer and currently at 6.5%, withdrawals under the 4% rule will increase considerably. Retirees now need more money just to maintain their lifestyle. This means their investment portfolios will need to earn higher returns or the portfolio will quickly be depleted.
Another issue is market volatility. With the increase in interest rates, Wall Street has taken a beating the past 12 months, at one point entering bear market territory. The S&P 500 was down close to 20% in 2022, while the Nasdaq fell 34%. Despite the market downturn, stocks are still trading at about 36 times corporate earnings over the past decade -- double the historical average. This means that there may be more room for prices to fall. In addition, there may be an economic recession in the near future, adding more economic uncertainty to the future. During these periods, retirees will need to be even more cautious about making withdrawals to ensure they don't run out of money.
A better rule?
Due to these factors -- as well as longer life expectancies -- even Bengen himself has stated that in today's unprecedented economic situation, retirees will need to lower their withdrawal rate and cut back their spending. A recent Morningstar study shows that the 4% withdrawal rate is too aggressive, and retirees should start at a 3.3% withdrawal rate.
This lower rate gives retirees more cushion against inflation and market uncertainty so they won't run out of money too soon. In addition, if you're retiring, you should look at multiple sources of income during retirement -- such as Social Security benefits or pension payments -- so you aren't dependent on withdrawals from your retirement accounts. The key is to be flexible with your personal finances and keep a long-term financial view.
The traditional 4% rule has served retirees well for decades but may no longer be relevant due to rising costs and increased market volatility. Retirees should consider using a rate closer to 3.3% withdrawal rate instead, as well as looking into other sources of income. By doing this, retirees can ensure they don't run out of money during retirement.
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