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For decades, workers planning for retirement have used a simple rule to determine whether they had enough money set aside to retire. The so-called 4% rule led to a very simple mathematical conclusion: As long as you had 25 times the amount you expected to need for living expenses in your first year of retirement, then you had a very high probability of having your money last long enough to support you for the rest of your life.
Unfortunately, simple guidelines like the 4% rule aren't designed to handle extraordinary conditions in the financial markets. The conclusion of a recent research paper examining safe withdrawal rates from retirement accounts is that with bond yields at extraordinary low levels that are insufficient to cover the impact of inflation, using the 4% rule introduces far more risk than you can afford to take.
At the end of this article, I'll give you some strategies you can follow to preserve your retirement nest egg even under tough conditions like these. First, though, let's take a closer look at the reason that the 4% rule is in danger of failing investors, at least right now.
Professors Michael Finke and Wade Pfau joined Morningstar retirement expert David Blanchett in publishing a working paper aptly called "The 4 Percent Rule Is Not Safe in a Low-Yield World." The paper noted that under ordinary circumstances, following the 4% rule has historically led to a success rate of about 94% in helping retirees outlive their money.
Typically, the 4% rule assumes that retirement investors will split their portfolios between stocks and bonds. The stock portion of the portfolio ensures some modest level of growth to handle the rising inflation-adjusted withdrawals that the rule calls for in future years, while the bond portion is intended to provide a substantial part of the current income that retirees withdraw from their nest eggs.
The problem right now, though, is that retirees' bond portfolios aren't pulling their weight. The iShares Core Total US Bond Market ETF (NYSEMKT: AGG ) , for instance, yields just 2.5%, not coming even close to providing its share of cash for retirees to withdraw under the 4% rule. Even when you boost your time horizon, iShares Barclays 20+ Year Treasury (NYSEMKT: TLT ) fails to get you to the 3% level. Meanwhile, those seeking inflation protection via iShares Barclays TIPS Bond (NYSEMKT: TIP ) or similar investments are earning even lower returns, with negative real rates after inflation on TIPS of -1% as far out as 2020 and below zero extending 15 years into the future.
The paper concludes that if low real rates persist, then the chance of failure rises from 6% to 57%. Moreover, even if real rates revert to more normal conditions within five to 10 years, failure rates remain substantially higher, leaving retirees' prospects at risk.
What to do
How investors should handle this challenge depends on your situation. If you're still working and have time to save more, then adopting a lower withdrawal rate boosts your chances of success. Blanchett argues that a 3% withdrawal rate is a better starting point from a sustainability standpoint, although it requires you to boost your overall nest egg target by a third, to 33 times your expected annual income needs. That's a bit much for most people to make up in a short period of time.
For those already in retirement, using more high-risk assets is one way to improve yield. PIMCO Total Return Bond (NYSEMKT: BOND ) uses a variety of different types of bonds to try to boost returns, even as its distribution yield has been similar to its passive-ETF counterparts lately. High-yield junk bonds will give you better yields but with greater overall risks of default. And of course, the race into dividend stocks that has led to floods of inflows into Vanguard High Dividend Yield (NYSEMKT: VYM ) and other dividend ETFs introduces an entirely new level of risk, as the security of return of principal that bonds offer totally disappears with a stock investment.
Arguably the best strategy to follow with your retirement withdrawals is to find ways to trim the automatic upward adjustments that the 4% rule calls for. If you can handle spending increases at less than the rate of inflation, then you'll be able to withstand greater financial shocks in the markets without increasing your risk of running out of money. In the end, being able to be prudent with your budget is your best defense against financial uncertainty.
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Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.