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The complexity of financial planning makes people look at simple strategies for investing and money management as lifesavers. The well-known 4% retirement rule for taking withdrawals from your life savings after you retire is a great example of this phenomenon, as it promises to take the complicated topic of how to make your money last as long as you live and to simplify it into a one-and-done calculation.
Unfortunately, the 4% rule has come under attack lately, as market conditions both now and over the past decade have caused concerns about exactly how safe it is. Yet the beauty of simple rules is that by adapting them slightly, you can often hang on to the simplicity of a strategy while making it better able to withstand adverse conditions. Let's take a look at the controversy over the 4% retirement rule as well as some potential fixes to help you overcome its shortcomings.
How the 4% rule works
Using the 4% retirement rule couldn't be easier. Here's how it works: When you retire, you take the total value of your retirement portfolio, and then you divide it by 25. That establishes the amount that you can budget as withdrawals from the portfolio during the first year. Then, for every year after that, just increase the previous year's amount by the rate of inflation.
The beauty of the rule is that it's easy to calculate, but it also had support from market history. Looking back for decades, the 4% retirement rule was adequate to weather past market downturns while still leaving you with money left over even after 30 years or more of retirement, as long as you maintained a balanced asset allocation with money both in stocks and in bonds.
Does the rule really work?
Recently, though, we've seen some extraordinary market conditions. Since 2000, investors have had to get through two brutal bear markets for stocks. Although good performance from bonds during the so-called Lost Decade helped to keep overall retirement-portfolio returns up, retirement portfolios based on the rule were causing big problems for retirees as early as 2009, with the market meltdown the previous year having cut some stock-heavy portfolios in half.
Of course, stocks have soared since then, but critics of the 4% retirement rule now point to extremely low bond yields as being problematic for new retirees. Historically, higher bond yields have been able to finance a much larger portion of the overall 4% withdrawal rate, which has left retirees having to sell a small amount of stocks and bonds in order to produce the cash they need. But even with rates having risen sharply over the past couple of months, the longest-term bonds still yield less than 4%, and shorter-duration bonds have much lower yields. The popular active bond ETF PIMCO Total Return (NYSEMKT: BOND ) , for instance, has a distribution yield of just 2.7% despite having a roughly eight-year effective maturity, and although it believes it will achieve a 3.7% yield to maturity, it boosts its yield by holding a mix of mortgage-backed securities, corporate debt, and international bonds.
Because of low bond yields, many retirees have turned to dividend-paying stocks for yield, but by doing so, they've also increased the risk that the 4% retirement rule won't work. Dividend ETFs Vanguard High Dividend Yield (NYSEMKT: VYM ) and iShares Select Dividend (NYSEMKT: DVY ) both offer yields between 3% and 4%, but the average earnings multiples of the stocks they own have gotten fairly pricey recently, trading at around 16 and 19 times earnings respectively. Even the more conservative dividend ETF Vanguard Dividend Appreciation (NYSEMKT: VIG ) , which looks more at historical dividend growth rather than current yield in choosing stocks, has a multiple of 16 -- higher than you'd want from the slower-growth companies that often end up being the best dividend payers.
How to adapt
To make the 4% retirement rule work for you, there are several things you can do. The clearest solution, though usually the hardest, is to reduce your withdrawal rate during bad markets. For those with a long time before retirement, several experts have suggested looking at 3% withdrawal rates as being more sustainable. Yet obviously, if you're already in retirement or close to it, then it's impossible to engineer the 33% increase in the size of your nest egg that you'd need in order to keep your withdrawals the same under a 3% rule as they would be at 4%.
A more manageable solution for many investors is to skip inflation adjustments after years of bad portfolio performance. That won't increase the security of your nest egg nearly as much, but it might be the best compromise in trading off your need for current income with future demands on your money.
Finally, keep in mind that your lifetime spending pattern might not match the rule's assumptions. If you expect to live a more lavish lifestyle during your earlier retirement years but scale back as you age, then you might not need to make adjustments to the rule.
Nevertheless, what the recent controversy shows is that the 4% retirement rule isn't quite the simple yet perfect solution that many people hope for. As a guideline, it's useful, but you shouldn't put your retirement portfolio entirely on autopilot.
If you want to get yourself set up for a prosperous retirement, the smart thing to do is to get your investments in order to make the most of the 4% retirement rule. Put simply, the best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.