Please ensure Javascript is enabled for purposes of website accessibility

How 2020 Broke Retirees' 4% Rule

By Adam Levy – Oct 1, 2020 at 10:20AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

And what you can do about it.

If you're planning for retirement, you may have heard of the 4% rule. The rule says you can safely withdraw 4% of a retirement portfolio's balance in the first year of retirement, then adjust the withdrawal for inflation every year after that. The model assumes a steady 50/50 split between stocks and Treasury bonds. Following the 4% rule should mean you'd never fully deplete your portfolio over a 30-year retirement period.

But 2020 might've changed all that. Someone retiring today might not be able to expect the same level of returns that the markets provided for the past 150 years. Here's why.

A mason jar full of coins labeled Retirement.

Image source: Getty Images.

Unprecedentedly low interest rates

With the economy in distress in March, the Federal Reserve dropped the target Fed funds rate by one percentage point to between 0% and 0.25%. It previously did the same thing during the 2008 financial crisis, and it kept the rate near 0% through 2015. The difference this time is Treasury bill yields were already near their record lows before the Fed's actions.

Ten-year Treasury bills currently yield about 0.65%. In early February, they yielded 1.5%, a rate previously seen only in the summers of 2012 and 2016. The only other time the 10-year Treasury bill yield fell below 2% was 1941.

Investors and lenders base the price of bonds and debt on treasury bill yields, which are seen as risk-free since they're backed by the U.S. government. As a result, interest rates and bond yields have dropped across the board because of the Fed's decision in March. And there are no plans to raise the rate any time soon.

Most of bonds' forward returns are based on their current yield. Bonds will appreciate in value, but only when prevailing interest rates decline. Since there's practically no more room for rates to decline -- the Fed wants to avoid negative interest rates -- there are very little returns left in bonds at today's prices. As a result, retirees shouldn't expect the bond portion of their portfolio to contribute much to overall returns.

Stocks have gotten really expensive

The stock market crashed in March, but it's come roaring back. Investors have been piling into stocks, with the major indexes fully recovering to their February highs in just a few months. Meanwhile, the underlying businesses for most stocks aren't any better off than they were before the pandemic hit. In fact, most of them have worse outlooks.

^IXIC Chart

Data by YCharts.

So why are stocks trading back near their highs? One explanation is investors are willing to accept lower returns from stocks, because they can't get the same returns they were used to in other markets, like the bond market.

Investors are paying much more per dollar of earnings today than they were just four years ago when bond yields were at their previous lows. The S&P 500's cyclically adjusted price-to-earnings ratio, or CAPE, was at 26.7 in July 2016 when the 10-year Treasury yield fell to 1.5%. That number climbed to 32.4 at the start of September, when the 10-year Treasury yield was just 0.67%. The market's since pulled back to a CAPE ratio of 30.7 as of this writing. For reference, the S&P 500 CAPE ratio was just 13.9 at the start of 1941, when 10-year Treasury yields last dipped below 2%.

Save a few months in 2018, the only other times stock prices were this high relative to their earnings were during the dot-com bubble and in the couple of months leading up to the 1929 crash. That's not to say another stock market crash is coming, but investors shouldn't expect stock prices to keep climbing at their current rate without significant improvements in earnings for the underlying businesses.

Investors should be planning for lower expected returns from both stocks and bonds than their historical averages for the foreseeable future. As a result, withdrawing 4% of your portfolio at today's value and maintaining that withdrawal amount for 30 years probably has a higher risk of ruin than ever before.

What can retirees do?

The simplest thing retirees can do is to lower their withdrawal rate. 

That may mean living on less in the early years of retirement, saving more each year, or working longer and maintaining your current spending and savings habits. Or perhaps you can find a new source of income in retirement to supplement your investment portfolio.

You might consider more dynamic withdrawal strategies. You can adjust your withdrawal amount based on the previous year's performance, withdrawing less as the market declines and more as it increases. If you want to get more complicated, you can adjust your withdrawal percentage based on the IRS's required minimum distribution rules or another variable percentage withdrawal strategy.

Keeping an eye on market conditions and maintaining reasonable expectations is the best thing you can do as you plan for retirement. For some, it's better to err on the side of caution and leave a lot of money to charity and inheritance if things go better than expected. For others, it's worth taking the risk of having to go back to work or otherwise supplement a retirement portfolio to live the life they want today.

The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
356%
 
S&P 500 Returns
118%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 11/26/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.