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 It aimed to determine what percentage of a retirement fund can be safely withdrawn each year.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 one should increase 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 seemed to suggest that the 4% rule could be used instead of a more sophisticated cash flow calculator.
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. One of the hardest decisions is to decide how much to withdraw so that the funds last a lifetime. It may be tempting to follow the 4% rule, as it’s so simple.
Does The 4% Rule Still Apply?
In the UK, research comparing US and UK historic market data suggests that the percentage would need to be somewhat lower than 4%, in order to have an equivalent safety margin.
As a rule of thumb, the 4% rule may well be good for coming up with a rough and ready estimate for the safe withdrawal amount at retirement. However it’s important to understand that it ignores a number of important factors.
Let’s say that using the 4% rule leaves a 5% chance of running out of money within 30 years. 5% may sound low, but retirees typically have a good chance of living more than 30 years. What’s more, life expectancy will almost certainly increase in the future. This means that the likelihood of running out of money during one’s lifetime could be much more than 5%.
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 safe percentage may be lower when you’re younger, and may be higher when you’re older.
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. You will experience a big drop in your standard of living. The 4% rule doesn’t help you work out how to balance your spending both before and after retirement to avoid this ‘cliff edge’.
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 most of us would wish to trim our spending, at least temporarily, in the face of market meltdown. You may also want to spend a bit more if your investments have outperformed the market. The 4% rule doesn’t really address this.
Depending upon your willingness to adapt your spending to market conditions, you may consider it acceptable to start with more than a 5% chance of running out of money, taking the view that you will preempt the danger of actually running out by adapting your spending. The 4% rule doesn’t allow for such a nuanced approach.
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. We really need to take both of these into account to determine the safe withdrawal amount.
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. Put simply, the higher your guaranteed income, the more risk you may feel comfortable with in supplementing your income.
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 fall-back 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 safe withdrawal rate may be higher or lower, depending on the value of your home.
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’s safe for a single person may have an unacceptably high chance of running out of money for a couple.
The 4% rule assumes that your only motivation is to maximise spending in your lifetime. It takes no account of any wish you may have to leave an inheritance.
Our Cash Flow Calculator
The interplay between all these factors is highly complex. The 4% rule is fine to help you start to think about drawing down from your retirement fund. But clearly it isn’t going to come up with the correct ‘magic number’ withdrawal amount for most people. A much more sophisticated cash flow calculator is needed that 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, it should always come down to expert human judgement as to the best strategy. So no matter which tool you use, you should always take advice 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 confidence in their decisions.