Is it time for retirees to retire the 4% rule?

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December 02 2021
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New economic realities are challenging long-held assumptions about how retirees should tap into their wealth.

Conventional wisdom when it comes to retirement may be in need of an update.

According to Morningstar senior investment analyst Shani Jayamanne, the 4 per cent withdrawal rate typically used by retirees may be too aggressive in today’s economic climate.

“All things being equal, we suggest retirees should instead target a 3.3 per cent withdrawal rate,” she recommended.

While Ms Jayamanne admitted that the question of how much money is needed for retirement was a complex one, she said that a lack of clarity around mortality has led to widespread adoption of the 4 per cent rule.

She said that this shorthand approach to wealth management had become the go-to default over a more holistic consideration of whether or not it actually meets the needs of a given modern retiree.

“The 4 per cent rule is the basis of retirement plans across the world, heralded as a ‘safe’ withdrawal rate from your portfolio,” she said.

In practice, the 4 per cent isn’t valuable because it provides a goalpost but because it provides investors a way of easily estimating the amount of money they need for retirement.

“A few simple calculations and the 4 per cent withdrawal rate leads to the magic number that is the lump sum you need in retirement,” she explained.

However, Ms Jayamanne said the assumptions and objectives underpinning this particular approach to wealth management are largely reflective of the economic conditions in which it became popular.

The 4 per cent rule was popularised by US financial adviser Bill Bengen back in 1994, who undertook a study to better understand how much his clients could take out of their portfolios without running out of money.

According to Ms Jayamanne, Mr Bengen’s strategy sought to solve the retirement issues presented by the sequencing of returns.

“In times of falling markets, taking money out of your account to pay for your expenses means you don’t have time to save and invest to make up for poor returns. This means that it is difficult to make up for the poor returns you received early in retirement,” she explained.

The issue here is that Bengen’s research was primarily based on back-testing, which meant that it only factored into account historical circumstances.

“Understanding the past is necessary, but it is insufficient for anticipating the future,” Ms Jayamanne said.

She argued that retirement forecasts that incorporate current conditions are much more useful than those that rely on older data.

Mr Bengen’s analysis was done in an economic environment quite different to today’s combination of low bond yields, high stock valuations and rising inflation.

“After looking at the state of the market, it is clear that the low return environment requires investors to create a little wiggle room,” she said.

One way of achieving this is flexible withdrawal strategies.

Ms Jayamanne said that flexible and guardrail strategies could ensure that retirees don’t overspend in periods where the market is weak while also boosting their returns during booms.

”If these withdrawal strategies sound complex it is because they are complex. That is the beauty of the 4 per cent rule which gives you a single withdrawal percentage increased by inflation,” she said.

“It doesn’t require sacrifice and it doesn’t require complex annual calculations to decide what you will spend.”

About the author

Fergus is a journalist for Momentum Media's nestegg and Smart Property Investment. He likes to write about money, markets, how innovation is changing the financial landscape and how younger consumers can achieve their goals in unpredictable times.

About the author

Fergus is a journalist for Momentum Media's nestegg and Smart Property Investment. He likes to write about money, markets, how innovation is changing the financial landscape and how younger consumers can achieve their goals in unpredictable times.

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