Is The 4% Rule Right For You
The 4% withdrawal rule is one of the most popular yet controversial concepts in the personal finance world. As with all things financial, it is hotly debated, so let’s break it down.
What is the 4% Rule?
The 4% rule refers to a popular philosophy based on past market data to plan out how much to “safely” withdraw from a retirement fund, without running out of money.
The core idea being the average retiree could withdraw up to 4% of their retirement fund in their first year of retirement. Then by adjusting for inflation in subsequent years, they could have a 90% chance of not running out of money for at least 30 years.
For example, someone who retires at 65 could expect their money to last until they turn 95 with a 90% success rate.
It is necessary to understand, particularly here in Australia, that the study is based on US data. We will get into this below.
The Origins of the 4% Rule
The origins of the 4% rule are attributed to Bill Bengen, a financial adviser in Southern California, and further popularised by three professors from Trinity University. You can read their papers HERE and HERE. These studies are informally referred to as the 4% Rule and the Trinity Study and are based on the same data and similar analysis.
The studies used similar data on stock and bond returns over the 50-year period from 1926 to 1976, focusing heavily on the severe market downturns of the 1930s and early 1970s, and how they impacted portfolio withdrawals.
For Australians
The 4% formula differs from Australia’s minimum pension drawdown rules, which are based on a percentage factor for increasing age rather than inflation rates.
Australian tax rules also require minimum super withdrawal rates, Under 65, drawdown begins at 4% for ages 65-74 and then 5% for ages 75-79 6%, and so on.
These drawdown rates can pose a barrier to applying the 4% rule across an entire financial portfolio, including savings accounts and super accounts.
Researchers at Griffith University in Australia produced a paper in 2015 for the safe withdrawal rates in a number of different countries including Australia. Based on the historical data for a 50/50 portfolio of stocks/bonds the safe withdrawal rate in Australia for a 30 year period was only 2.96% rather than 4%.
Morningstar recently re-ran the numbers for Australian retirees in a paper in 2021 found a safe initial withdrawal rate at 3.3% for balanced portfolios (using an expected inflation rate of 2.21%).
Reports such as these are a great example of how the 4% findings and conclusions can change depending on different metrics.
The Advantages
The obvious benefit is that the 4% rule is easy to understand and simple to follow and,
If successful, provides for a predictable and steady income in retirement, without running short of funds.
The Disadvantages
There are several scenarios in which the 4% rule might not work for a retiree.
For example, it is based on a rigid investment portfolio that contains 60% shares and 40% bonds. Investment portfolios may not have or want this particular weighting.
Based on the past performance of the markets. What was considered a safe investment strategy in the past may not be a safe investment strategy for changing market conditions in the future.
The 4% Rule is focused on preparing for retirement at age 65. If you're hoping to retire early or want to work past age 65, your long-term financial needs will be different.
It also is based on a static withdrawal rate, however, lifestyles don’t follow the same amount of spending every year. Most retirees have a higher expenditure in the early part of their retirement, devoting more time to hobbies or travel. Spending then falls in the middle part of retirement, before rising again due to higher healthcare expenditure later in life.
Rounding Up…
While following the 4% rule can make it more likely that your retirement savings will last the remainder of your life, it doesn’t guarantee it.
It is interesting to note that a 4% withdrawal may also be derived from deposits, rentals, capital gains, dividends, interest, or compounding than the capital amount.
In a bear market, these are expected to be more than 4%, which an investor may reinvest into the market, increasing their capital. However, in declining years, an investor may need to sell their part of their capital or investments.
Although financial rules of thumb are great starting points for saving and investing, they are no substitute for a personalised financial plan based on your personal circumstances.
At Shape Financial, we are strong advocates for having a well-diversified portfolio for a stable and solid future. For long-term planning and a personalised withdrawal strategy tailored to you, please don't hesitate to reach out to us.