When it comes to anything as inherently complicated as retirement planning, its hard to underestimate the appeal of a strategy that offers simple answers. Save precisely $1 million. Or exactly 10 times your annual salary. Those goals may not be easy to hit, but they are at least easy to wrap your head around. Then, on the other side of that coin is the question of how much of your hard-saved nest egg you can afford to spend each year once you do retire. You don't want to be too cautious and live like a pauper when you could afford some luxury, nor to burn through it too rapidly and wind up broke and struggling to get by on just your Social Security.
Into the haze around this question dropped noted financial advisor William Bengen, who in 1994 did a comprehensive study of decades of market data. His conclusion was that even in periods that included the worst stock market performances of the century, a 4% withdrawal rate would still allow retirees to stay solvent for at least 33 years. The 4% Rule was born. Unfortunately, like so many other things from the 1990s -- AOL, jean shorts, baggy pants, and an awful lot of sitcoms -- this guideline has aged badly. To explain why, Motley Fool Answers hosts Alison Southwick and Robert Brokamp have a special guest -- personal-finance writer Maurie Backman. In this segment of the "retirement myths"-focused episode, she reveals just what has changed in the world of investing that makes Bengen's rule more of a risk than it used to be.
A full transcript follows the video.
This video was recorded on Nov. 13, 2018.
Alison Southwick: No. 5 -- our fifth and final myth we're going to debunk today. You can plan on withdrawing 4% of your nest egg annually in retirement.
Maurie Backman: That's classically been the convention. The "4% Rule" was invented -- or initiated, instituted, or whatever you want to call it -- back in the mid-'90s and it basically states that if you begin by withdrawing 4% of your nest eggs value during year one of retirement and adjust subsequent withdrawals for inflation, your nest egg should conceivably last you for 30 years. And while I think it's a good baseline to follow, I don't necessarily think that we should be following it to the letter, and here's why.
Back when that rule was established, first of all, we were in a very different interest-rate environment when it came to bonds, and now we are not in that sort of environment. So if you have a portfolio that's reasonably loaded with bonds -- let's say anywhere from 40%-60% bonds, which is the general recommendation -- you're not going to be generating the same sort of income from those bonds as you were back then. And that's obviously going to limit the extent to which you can withdraw that aggressively.
The other thing is that the rule makes a lot of assumptions. It does assume a fairly even split on stocks and bonds, which not everybody has. It assumes that you didn't retire on the really early side. People are living longer these days. The Social Security Administration says that, I think, about 25% of 65-year-olds will live past 90. So if you retired at 55, which some people are doing, all of a sudden you've got a little bit of a shortfall, there, if you start withdrawing at 4%. So I would say use it as a guideline but be careful with it.
Robert Brokamp: It originally came out, as you pointed out, in a study in the mid-'90s from Bill Bengen. In subsequent studies that he came out with, he actually moved it up to 4.5%. And he recently moderated a Reddit discussion and said, "I still stand by 4.5%." But he recognizes and values the research from other folks, from people like Wade Pfau who say, "No, it really should be closer to like 3% because, like you said, very low interest rates, high stock valuations."
Really the bottom line is to choose something that is within that range and be prepared to be flexible, because regardless of where you start, the research shows that one of the best things you can do is if the market does go down, or you don't get from bonds what you were hoping, that you can cut back on your spending during those tough times and then wait until your portfolio recovers. If you can do that, whether you choose 3%, 3.5%, 4%, or 4.5% is less important than your ability to cut back when the market is down.