Retirees, planners, and advisors alike have all used the 4% rule for decades now. Since its discovery in the 1990s, the 4% rule is very straightforward: You withdraw 4% of your savings in the initial year of retirement and inflate it proportionately in subsequent years. This has been an age-old strategy for having a strong portfolio and money that lasts for 30 years.
Unfortunately, the economic landscape that created this rule has since changed significantly. Increased life expectancies, inflation, rising healthcare costs, and lower projected investment returns pressure old-school retirement planning strategies. This implies that the original rule may no longer apply in modern times, nor could it offer the security it once did.
This forces retirees to critically consider if the 4% rule should still be followed, especially in an economy as volatile and uncertain as it is today. Such static withdrawal tactics might need to be updated to adjust to modern landscapes. New research suggests an adapted approach rooted in flexibility, diversified strategies, and dynamic adjustments to build a more resilient and reliable retirement plan to maintain strong, sustainable incomes.
What is the 4% Rule?
Historical Origins
The 4% rate has long been regarded as a safe withdrawal rate, with William Bengen being the first to introduce the concept of the rule in 1994. The financial planner aimed to help people in retirement safeguard their savings and make them last. He conducted an innovative analysis by looking at historical U.S. market data and analyzing 30-year retirement periods. He included rough economic periods, like the stagflation of the 1970s, and the Great Depression in his research.
What he concluded was groundbreaking for the time: individuals withdrawing 4% of their retirement fund in the first year and revisiting it annually to cover inflation could make their savings last for at least 30 years. Based on a portfolio split between intermediate-term government bonds and U.S. stocks, Bengen’s initial research reflected the typical asset allocation.
After that, the rule quickly gained popularity as it granted retirees a simple, actionable framework for balancing their income needs with savings sustainability. However, the rule was created based on assumptions that were tightly linked to the late 20th century’s economy, which looks very different from the present day.
Underlying Assumptions
Built on the realities of the 1990s, the 4% rule reflected outdated key assumptions. For example, market growth expectations were much higher, and bond yields were stronger than today, largely because U.S. equities delivered robust real returns in the late 20th century.
Secondly, inflation proved to be much more stable. It was a manageable factor when planning financially long-term, with inflation averaging around 3% annually. Additionally, retirement periods aligned with the average life expectancy at the time, which was estimated to be roughly 30 years.
Now, this environment for retirees looks drastically different. Lower expected returns are forecasted for bonds and stocks in the next decade, creating a problematic climate for portfolio growth. Inflation has become more volatile, with dramatic spikes eroding purchasing power in recent years. During all of this, life expectancy has risen, with retirees potentially needing to stretch their assets over 35+ years.
The combined realities urgently require questioning the static 4% withdrawal rate and considering whether more adaptive and flexible strategies are now essential to financial retirement security.
Why the 4% Rule Is Under Pressure
Longer Life Expectancy
Increasing life expectancies have been a change that significantly impacts retirement planning. In 2023, the average life expectancy was roughly 78 years in the U.S., according to statistics found by the CDC (Centers for Disease Control and Prevention). People who reached 65 were found to live for another 20 years on average, possibly. Similarly, the Social Security Administration has estimated that one in four 65-year-olds will live past 90.
If longer life spans are considered, the average portfolio period changes. Retirees must now potentially plan for 30 to 35 years of income needs, if not longer. Outliving savings becomes a real risk if withdrawal strategies can not adapt to the flexible nature of our economy. Personal health expenses, inflation spikes, and unexpected market downturns can severely affect retirement plans. Planning for a horizon of around 34-40 years may be necessary to ensure financial security during retirement, considering that the original 4% rule assumed 30 years.
Lower Expected Investment Returns
Longer retirements are not the only factor that presents challenges in today’s investment landscape. Return expectations are much lower than in the past. Projections show that in 2024, U.S. stocks will deliver average annual returns of around 4.2% to 6.2% over the next decade, whereas U.S. bonds are predicted to yield between 4.8% and 5.8%. The forecasts are considerably lower than in the 1980s and 1990s, when bond yields often topped 5% and equities delivered double-digit gains frequently.
Due to high equity valuations and lower starting bond yields, it will be much less likely in the near future to achieve average returns from the past. These lower returns mean that traditional practices regarding safe withdrawal rates must be reconsidered for retirees depending on portfolio withdrawals. Lower returns and longer retirements combined indicate that strictly sticking to the 4% rule could potentially put retirees at risk for early fund depletion, primarily if a large market downturn occurs in early retirement. This is also known as sequence-of-returns risk.
Inflation’s Erosion of Purchasing Power
One of the most serious and immediate threats to applying the 4% rule today is the reemergence of inflation. Although prices have been relatively stable and consistent for decades, we have recently seen an exponential inflation spike in the U.S. economy starting in 2021. In June 2022, inflation reached a record high of 9.1%, the highest in over 40 years.
Severe inflation has moderated slightly since then, although sustained price hikes and their effects remain a worry in sectors relevant to retirees. Healthcare, housing, and long-term care have increased costs faster than the Consumer Price Index (CPI). For example, a private room within a nursing home is estimated to cost over $120,000 per year in 2024, based on a Cost of Care survey by Genworth.
While the original 4% withdrawal rule does indeed account for inflation by annually adjusting the rate accordingly, it becomes a problem when inflation surpasses portfolio growth for longer periods. Only increasing withdrawals to equal inflation can easily and quickly deplete retirement savings. Retirees naturally spend a bigger chunk of their income on services in the healthcare sector compared to the general population. This means that such rising essential costs can disproportionately affect them.
In order to maintain purchasing power, retirees could possibly have to adjust to dynamic withdrawal plans, consider structures developed to protect against inflation, such as Treasury Inflation-Protected Securities (TIPS), and continually track their own spending flexibility. If the goal is to build a strategy that can withstand today’s challenging economic landscape, it becomes crucial to understand the relationship between retirement costs and inflation.
Modern Alternatives to the 4% Rule
Dynamic Withdrawal Strategies
Rather than continuing with a fixed withdrawal plan adjusted according to inflation, dynamic withdrawal strategies provide retirees with a means to alter their spending in direct response to their portfolio performance. The aim is to take advantage of stable markets when the conditions allow it and preserve the portfolio during market strain while sustaining a durable income.
One popular and widely known dynamic system is the Guyton-Klinger Guardrails Strategy, engineered by researcher William Klinger and financial advisor Jonathan Guyton. This strategy introduces “guardrails,” developed to activate annual withdrawal adjustments once the portfolio value rises considerably or dips relative to a baseline goal. For instance, retirees can reduce their withdrawals once the portfolio falls to a certain percentage. On the other hand, if the portfolio grows significantly, users can increase spending limits.
Benefits:
- Longevity protection: It helps protect against early depletion of retirement funds by encouraging reduced spending when the market becomes challenged. This can give investments more recovery time and prolong the lifespan of the assets over multiple decades.
- Spending flexibility: It allows for higher spending during better markets while avoiding compromising long-term sustainability.
- Behavioral support: A system based on rules can help retirees make better decisions during market turmoil. Guardrails offer stability with fixed guidelines on how and when to adjust spending.
Drawbacks:
- Income variability: Fluctuations in income could happen frequently, and retirees must accept that this will be a factor. This is an unfortunate downside to dynamic withdrawal strategies. It might be challenging for those with lifestyle commitments or rigid expenses.
- Complexity: Implementing this strategy requires constant monitoring of portfolio status and frequent recalculations of withdrawal amounts. This added layer of complexity may be overwhelming to retirees who prefer a simpler approach.
- Communication challenges: Individuals in a partnership require open communication to agree on flexible spending habits and a shared commitment to their financial goals, which can introduce potential strain.
Lower Initial Withdrawal Rates
Another recommended adaptation is simply starting with a lower initial withdrawal rate at the beginning of retirement. Research recommends starting retirement with a 3.7% withdrawal rate, which would suit the modern market environment more appropriately. Starting with a lower rate sets retirees up for a better chance of success in offering increased flexibility in the years ahead, based on inflation and actual investment returns.
For example, a retiree following this strategy, beginning their retirement with $1 million in savings, would withdraw $33,000 in their first year instead of $40,000 under the original 4% rule. This greatly improves the portfolio’s ability to survive in tense market conditions in the earlier years when sequence-of-returns risk is most critical, although it may feel like quite a considerable reduction at first.
By lowering that first withdrawal rate, retirees are building a stronger barrier against market and portfolio volatility, providing them with the resilience to perhaps increase spending at a later stage should returns exceed expectations. This is a rather conservative approach but offers pragmatic adjustments that prioritize financial sustainability and recognize the instabilities of the modern investing landscape.
Bucket Strategies for Retirement Planning
The bucket strategy offers a practical structure for improved management of retirement withdrawals. It allows the separation of assets into various “buckets”, based on the timeframe for when the money will be needed. Retirees typically segment their assets into three different buckets:
- Immediate needs (0-3 years)
Assets in the first bucket are generally held in low-volatility and highly liquid modes, such as money market funds, cash, or short-term government bonds. The main goal is preservation rather than growth, which ensures savings are available whenever needed, regardless of the market conditions.
- Intermediate needs (3-10 years)
Assets in the second bucket are allocated to cover anticipated spending, typically in the third to tenth year of retirement. They are invested in a variety of bond funds, income-generating investments, and intermediate-term bonds. Although slightly more vulnerable to market change, this bucket prioritizes growth and stability.
- Long-term growth (10+ years)
This bucket’s purpose is to support longer-term growth to facilitate a retiree’s income stretching over decades. This part of the portfolio is often invested in real estate investment trusts (REITs), stock funds, and general growth-based assets. Since this bucket won’t be touched for years, retirees can endure market changes while striving for higher returns, which will help them withstand inflation.
The bucket strategy certainly reduces sequence-of-returns risk. Should retirees face a stock market decline, they can withdraw funds from the first two buckets instead of selling equities. Alternatively, markets can top up shorter-term buckets with funds acquired from the third bucket whenever markets gain strength.
This approach offers retirees both a practical and psychological advantage. It alleviates anxiety by ensuring that near-term needs are met and secured, and helping them avoid forced selling during market crashes. Retirees can adjust how each bucket’s assets are taken from and refilled based on economic conditions; thus, the bucket strategy also naturally supports a dynamic withdrawal system.
The Risks of Overcorrecting
It is important to remember that being too conservative also has risks, while retirees should remain careful when it comes to withdrawal rates in an unstable economic environment. A fine balance needs to be struck, as some may overcorrect by significantly reducing their spending, which may lead to an accidental decrease in quality of life during years that were meticulously saved and planned for.
Underspending is a clear hidden cost here, which takes the enjoyment out of retirement and can possibly lead to feelings of remorse due to not living comfortably and missed opportunities like pursuing hobbies or traveling.
Fear-Driven Underspending
Decision-making driven by fear may push people to hoard their assets, even though they have more than enough resources to sustain higher spending. Research into behavioral finance gives us more insight into why this happens.
Loss aversion is a concept that describes situations in which people can feel losses and their pain more intensely than the satisfaction of gaining. This idea forms part of the Prospect Theory, developed by Amos Tversky and Daniel Kahneman.
This can manifest within retirement through the overwhelming fear of running out of money, which may cause retirees to rather underspend, even if they likely carefully planned for their retirement savings to be sustainable. Sometimes, it can be a psychological factor for people who have had saving mentalities throughout their whole working lives, retirement possibly being the very reason, thus making it difficult for them to transition into spending that money.
Finding a Balance
Finding a lasting balance is key to avoiding the risks of under- and overspending. By opting for a more flexible withdrawal strategy, retirees can remain financially secure while also enjoying their savings and the results of their hard work. To achieve this, a flexible withdrawal strategy that specifically adjusts based on portfolio status, changing lifestyle needs, and life expectancy updates would be optimal.
Retirees can reap the benefits from setting spending guardrails, building contingency plans, and frequently reassessing their financial situation, rather than sticking to rigid, fixed withdrawal rates. Being open to using a trusted financial advisor can also offer them valuable suggestions and guidance that might boost their confidence in making more intelligent decisions.
Retirement should ultimately be about achieving a balance between maintaining financial security and a good quality of life. A retirement plan that prioritizes fine planning and spending based on relevant needs can help retirees protect their wealth and well-being during these years.
Actionable Tips to Future-Proof Your Retirement
Planning for retirement happens continually. It’s a process that needs constant attention and adjustments through the evolution of market conditions, economic realities, and personal circumstances. Consider the following actionable steps for retirees to strengthen their portfolio longevity and resilience:
- Adjust your withdrawal strategy every few years:
Scheduling periodic reassessments of withdrawal rates would be much more pragmatic than relying on a set, rigid model. Adjusting your withdrawal strategy based on portfolio performance and inflation changes can set you up for success and avoid unnecessary underspending or fund depletion.
- Portfolio testing against various market scenarios:
To test how sustainable your current strategy is, running simulations may reveal the answer. Retirees can use a range of possible market outcomes, like periods of high inflation, recessions, and longer bear markets. Many financial advisors offer simulations like Monte Carlo for retirees to grasp their risk exposures well.
- Incorporate flexibility into your retirement budget:
Categorizing expenses achieves financial flexibility by separating essential, fixed expenses (think: healthcare, insurance, and housing) from more negotiable spending like travel and entertainment expenses. Thus, expenses can be adjusted according to the current market performance without compromising the essential needs of retirees.
- Diversify across assets:
Maintaining a varied portfolio that includes alternative investments, bonds, stocks, and cash equivalents is a great tool for cushioning against market shocks. Allocating your assets should simultaneously reflect long-term growth and shorter-term income stability.
- Consult financial advisors for personalized guidance:
By providing objective advice customized for your specific needs, circumstances, and risk tolerance, you can utilize the services of an independent fiduciary advisor, which can add considerable value to your portfolio. They can also assist with managing behavioral biases to guarantee that your withdrawal strategies align with economic changes.
Incorporating these proactive steps in a retirement withdrawals approach can help preserve all assets, a sustainable income, and a retiree’s confidence during more turbulent markets.
Flexibility, Not Rigid Rules
While it would not be entirely fair to completely disregard the original 4% withdrawal rate rule when it comes to retirement planning, it does remain a rather rigid rule that prohibits standard application for most retirees. As the economic landscape on which the original rule was based has changed remarkably, so must the accompanying strategies used to support a sustainable retirement.
Modern retirees must use flexibility, adaptability, and consistent portfolio monitoring as a baseline when planning for financial retirement. Navigating the volatile nature of our current economy, including inflation and longevity risk, can be tricky, but it can be significantly easier with dynamic withdrawal strategies, diversified portfolios, tested budgets, and realistic starting withdrawal rates.
The creation of retirement plans capable of adjusting to changing conditions, whether personal or economic, can help retirees preserve their purchasing power, keep their quality of life, and preserve their assets across many years and decades.
New research, improved accessibility to professional guidance, and new tools prove that today’s retirees are much better equipped than in the past. If these resources are applied effectively, financial security during retirement will be more than successful, enabling retirees to survive and truly thrive.
Featured Image Credit: Photo by Optical Chemist; Pexels
