There’s an ongoing debate over whether retirees should ditch the “4% rule” for retirement account withdrawals, a decades-old rule of thumb for retirement income. Market volatility in recent years has made the rule suspect to many new retirees, but a new Morningstar study finds that the rule may still apply.
Do you have questions about creating a long-term plan for your retirement? Talk to a financial advisor today.
What is the 4% rule?
The 4% Rule, coined in 1994 by a financial planner named William Bengen, states that retirees can make a well-structured pension fund last for 30 years by withdrawing no more than 4% of the balance in the first year of retirement and adjusting subsequent withdrawals for inflation. Bengen’s research looked at every 30-year period of market returns and conditions going back to 1926. He found that even during the worst three decades for the markets — a period from October 1968 to 1998 — a retiree wouldn’t run out of money.
The rule’s popularity has fluctuated, and the strategy has drawn some criticism. That’s because the range of returns risks can come into play during bear markets, which happens when the first few years of withdrawals occur when the value of a retirement portfolio declines. Earlier this year, personal finance expert Suze Orman argued that the rule no longer made sense and that retirees should work longer and withdraw as little as possible, but no more than 3%.
How Morningstar’s Study Takes Into Account
Investment analyst firm Morningstar has been studying the safe withdrawal rate for the first year of retirement for several years in a row. Morningstar’s latest research shows that with stocks partially recovering, withdrawing up to 4% is once again a safe starting point.
“I estimate that retirees who withdraw income from an investment portfolio now can afford to withdraw as much as 4.0% as an initial expense ratio, assuming there is a 90% probability that there will still be money left over after a 30-year horizon,” writes Amy C. Arnott, CFA, portfolio strategist at Morningstar.
Morningstar’s research into the optimal initial safe withdrawal rate began in 2021, when the analysis recommended a withdrawal rate of 3.3%. For 2022, that rate rose to 3.8%. The research assumes a 90% success rate for a portfolio in which equities make up 20% to 40% of holdings. At the end of 30 years, the portfolio would still have value.
The big factor in this year’s assessment was a change in the long-term inflation estimate, which fell to 2.42% this year from 2.84% in 2022, along with improvements in returns on fixed-income investments such as bonds and cash accounts. Expected 30-year fixed-income returns (including cash) rose to 4.81% in 2023 from 4.44% in 2022. The study noted that while stock performance has improved so far this year, expected 30-year stock returns have fallen this year, falling to 9.41% from 9.88% in 2022.
The research shows that retirees who take a more flexible approach to withdrawals than a strict 4% rate adjusted annually for inflation are able to withdraw more money at the start of their retirement, while retirees tend to spend more money as they build a new lifestyle in retirement. These retirees should accept that their withdrawals will fluctuate from year to year and that they may have less money left over after 30 years. Consider talking to a financial advisor to create a personalized plan based on your goals.
Conclusion
The popularity of the 4% rule ebbs and flows, but it can be a good starting point for creating a safe retirement withdrawal strategy. A key consideration is how much money to withdraw in the early years of retirement, especially if the portfolio has lost value.
Tips for retirement planning
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A financial advisor can help you create a retirement income plan. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can schedule a free introductory meeting with your advisors to determine which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Social Security plays an important role in most people’s retirement plans. SmartAsset’s Social Security calculator can help you estimate how much your benefits will be worth based on when you plan to claim them.
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Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid—in an account that isn’t subject to big swings like the stock market. The tradeoff is that the value of liquid assets can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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