The 4% rule, a popular retirement income strategy, can be broken

Market conditions are putting pressure on the 4% rule, a popular rule of thumb for retirees to figure out how much money they can live on each year without worrying about running out later.

Withdrawing money from your nest egg is one of the most complex financial exercises for households. There are many unknowns – the length of retirement, spending needs (health costs, for example) and investment returns, to name a few.

The 4% rule aims to generate a constant annual income and to give seniors the assurance that their funds will last into a 30-year retirement.

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Simply put, the rule says retirees can withdraw 4% of the total value of their investment portfolio in the first year of retirement. The dollar amount increases with inflation (the cost of living) the following year, as it would the following year, and so on.

However, market conditions, namely lower expected returns for stocks and bonds, do not appear to be working in favor of retirees.

Given market expectations, the 4% rule “may no longer be feasible” for seniors, according to one paper published Thursday by Morningstar researchers. These days, the 4% rule really should be the 3.3% rule, they said.

Although the reduction may seem small, it can have a big impact on the standard of living of retirees.

For example, using the 4% rule, an investor could withdraw $ 40,000 from a $ 1 million portfolio in the first year of retirement. However, using the 3% rule, that first year withdrawal drops to $ 33,000.

The difference would be more pronounced later in retirement, allowing for inflation: $ 75,399 versus $ 62,205, respectively, in the 30th year, according to a CNBC analysis. (The analysis assumes an annual inflation rate of 2.21%, the average Morningstar projected over the next three decades.)

Retirees have enjoyed a “trifecta” of positive market developments over the past decades, according to Christine Benz, director of personal finance and retirement planning at Morningstar and co-author of the new report.

Low inflation, low bond yields (which pushed up bond prices) and strong stock returns have helped support investment portfolios and safe withdrawal rates, she said.

The dynamic may have lulled near-retirees into a false sense of security, Benz said.

Bonds are “very unlikely to post any significant gains over the next 30 years,” and high stock prices are expected to fall as they revert to the average, according to the report. The analysis admits that this outcome is probable but not inevitable.

(Although inflation has been historically high in recent months, Morningstar expects it to moderate over the long term.)

Investment returns are particularly important in the early years of retirement due to the so-called sequence of returns risk. Taking too much out of your nest egg in the first year (s) – especially from a portfolio that is declining in value at the same time – can dramatically increase the risk of running out of money later.

This is because there is less room for the portfolio to grow once the investments bounce back.

Of course, this analysis of the 4% rule has many caveats.

On the one hand, the 4% rule (and the updated 3.3% rule) only take into account investments in its portfolio. It does not take into account sources of non-portfolio income such as social security or pensions.

Retirees who delaying social security claim until age 70, for example, will get a higher guaranteed monthly income and may not need to rely as much on their investments.

In addition, the rule of thumb uses conservative assumptions. For example, he uses a 90% probability that seniors will not run out of money during a 30-year retirement.

Retirees who are comfortable with more risk (i.e. a lower probability of success) or who believe they will not live to age 90 can safely withdraw more money. important each year. (A 65-year-old man today goes live another 20 years on average.)

Perhaps more importantly, the rule assumes that a person’s spending does not adjust to market conditions. But that may not be a fair assumption – research shows that seniors typically fluctuate in spending until retirement.

Retirees have a few options in this regard to ensure the longevity of their investments, according to Morningstar. In general, these require less withdrawals after years of negative portfolio returns.

For example, retirees may forgo inflation-related adjustments during these years; they can also choose to reduce their typical withdrawal by 10% and return to normal once investment returns are positive again.

“There are a few simple adjustments you can make,” Benz said. “It doesn’t have to be a giant strategy; it can be a series of those incremental adjustments that can make a difference.”

However, there are trade-offs to be flexible. Primarily, these annual spending adjustments can cause large fluctuations in living standards from year to year.