Back in the 90’s, a US financial planner named William Bengen put forward an amazingly simple rule of thumb. It aimed to determine what percentage of a retirement fund can be safely withdrawn each year. He proposed that it’s safe to withdraw and spend 4% of the starting valuation in the first year. Then the rule assumes increasing the withdrawal amount by inflation in each subsequent year, irrespective of market conditions. Soon afterwards, economists carried out research involving Monte Carlo simulations. This research indicated that applying the 4% rule to a balanced portfolio had a 5% chance of running out of money within 30 years. This was interpreted by some as implying that the 4% rule might substitute for a more detailed cash‑flow model.
Retirees are no longer forced into buying annuities with their defined contribution pension funds. Many will therefore decide instead to generate retirement income by drawing down from their funds each year. A key problem facing many retirees is how much to withdraw so that funds last a lifetime. The simplicity of the 4% rule can make it appealing.
Does The 4% Rule Still Apply?
In the UK, research comparing US and UK historic market data suggests the percentage might be somewhat lower than 4%, in order to have an equivalent safety margin.
As a rule of thumb, the 4% rule may well be useful for producing a rough estimate of a withdrawal amount at retirement. However it’s important to understand that it ignores a number of important factors.
Longevity.
Let’s say that using the 4% rule leaves a 5% calculated chance of running out of money within 30 years. 5% may sound low, but many retirees live more than 30 years, and life expectancy may increase in the future. This means that the likelihood of running out of money over a full lifetime could be higher than the 30‑year figure suggests.
Starting age.
Not everyone retires at the same age. Obviously, the younger you retire, the longer your retirement fund needs to last. If you retire at 70, a 30 year horizon may seem reasonable. But if you’re considering retiring at 50, you have a fair chance of living another 40 years or even longer. In other words, the percentage implied by the rule may be lower when you’re younger and higher when you’re older.
Pre-retirement spending.
The 4% rule aims to determine sustainable spending during retirement. However if that spending level is much less than what you’re spending leading up to retirement, the transition into retirement will be difficult. It could result in a significant drop in standard of living at the point of retirement. The 4% rule doesn’t help you work out how to balance your spending both before and after retirement to avoid this ‘cliff edge’.
Flexibility.
If you start applying the 4% rule at retirement, and at some point later there’s a market crash, what do you do? In theory it should be ‘safe’ to increase your spending by inflation. But many people might choose to trim spending temporarily in the face of a market downturn. You may also want to spend a bit more if your investments have outperformed the market. The 4% rule doesn’t really address this.
Safety margin.
Depending their your willingness to adapt your spending to market conditions, some people may consider it acceptable to start with more than a 5% chance of running out of money, taking the view that they will preempt the danger of actually running out by adapting their spending. The 4% rule doesn’t allow for such a nuanced approach.
Risk aversion.
Each individual is different when it comes to their tolerance or aversion to risk. This can affect short-term decisions, such as exposure to Stockmarket volatility. It can also affect long-term decisions, such as the chance of running out of money in your lifetime. Both of these can be relevant when modelling withdrawal amounts.
Guaranteed income.
Most people will have some form of guaranteed income, now or in the future. For some it may only be the state pension. Others may also have defined benefit work pensions, or annuities that have already been purchased. Taking these into account are highly likely to change the acceptable safety margin for any withdrawal strategy. The level of guaranteed income can influence how much variability someone feels comfortable with.
Home equity.
Running out of money when you live in rented accommodation means you won’t be able to afford your rent. However, if you own your own home, the equity in your home can provide a fallback source of funds should the worst happen. This can either be via an equity release scheme (reverse mortgage), or by downsizing. In other words, the withdrawal percentage implied by the rule may be higher or lower, depending on the value of your home.
Couples.
The chances of at least one member of a couple living to any particular age are much greater than for a single person to live to the same age. This means that a 4% withdrawal that appears sustainable for a single person may have a higher chance of running out of money for a couple.
Legacy.
The 4% rule assumes the sole objective is to maximise spending during one’s lifetime. It takes no account of any wish one may have to leave an inheritance.
Our Cash Flow Calculator
The interplay between all these factors is highly complex. The 4% rule can help frame initial thinking about drawing down from your retirement fund. But clearly it is unlikely to produce a precise withdrawal figure for most people. A more sophisticated cash flow calculator can take factors such as these into account. In creating EvolveMyRetirement®, we set out to take account of as many such factors as possible, whilst still keeping it simple for the user to use.
Ultimately, expert human judgement plays a central role in determining a withdrawal approach. So no matter which tool you use, it is important to seek guidance from an independent financial adviser. However, having easy access to a high-quality cash flow calculator should assist savers and retirees alike to have greater clarity when considering their decisions.