As always, The Motley Fool cannot and does not provide personalized investing or financial advice. This information is for informational and educational purposes only and is not a substitute for professional financial advice. Always seek the guidance of a qualified financial advisor for any questions regarding your personal financial situation. If you'd like to submit your question for feedback, you can do so here.
How long will your retirement savings last? Nobody can say for sure. There are just too many moving variables to come up with an ironclad number. Indeed, much of the investment services industry exists specifically because the future is unknown. The best we can do is optimize and reoptimize our holdings as things change.
There is, however, some surprisingly specific statistical data that can help you improve your odds of not outliving your money, particularly if you're an early retiree. One of them is called the 4% rule. And the key to making the best use of this rule is knowing when to adhere to it and when you can (and should) bend it just a bit.
But first things first.
What's the 4% rule?
Never heard of it? It's not complicated. Conceived and calculated by financial advisor William Bengen back in 1994, the 4% rule simply says you can withdraw 4% of your retirement savings in your first year of retirement, and then increase that dollar amount annually by that particular year's rate of inflation. For example, a 4% distribution from $1 million worth of retirement savings would be $40,000. If average inflation rises to 2.5% over the next 12 months, the next year's withdrawal is increased by 2.5% to $41,000, and so on.
Image source: Getty Images.
OK, it's not quite that simple. Bengen is assuming your portfolio consists of exactly half stocks and half bonds. Based on historical market data as of 1994, the portfolio would likely support these ever-growing withdrawals only for a period of 30 years. That was fine, though, since that was longer than most retirees lived after they stopped working.
Much has changed since then, however. And it's those changes that merit a rethinking of the original 4% rule now.
Then and now
Perhaps chief among these changes is that most people are now living longer than they did then, yet retiring earlier at an average age of 62. The Social Security Administration reports that the average person in the U.S. who reaches the age of 65 will likely go on to reach at least 85, with half of them living beyond that point. That easily means more than 20 years' worth of retirement for most -- and even more for early retirees -- versus only about 15 to 20 years' worth of retirement 30 years ago. This, of course, means retirement savings need to last even longer.
And that's become increasingly difficult to muster. Interest rates on bonds have spent most of the period since then below the long-term averages that Bengen based his work on. And although the market's performed remarkably well since then, the bulk of those gains were driven by the technological revolution that won't be repeated.
Many pundits believe we're now entering a prolonged period of subpar market performance, in fact, as we recover from the proverbial hangover. For instance, Goldman Sachs believes the S&P 500 will see average annual gains of only 3% over the decade ahead.
Perhaps the biggest threat to the safe use of the 4% rule, however, is the market's volatility that has become the norm in the meantime. We're seemingly more likely to suffer prolonged and deep-cutting market weakness now than we were when Bergen did his earliest work. This raises the risk of making a sizable withdrawal from your retirement savings at the worst possible time, locking in losses and missing out on part of any recovery move.
Hence the need for so-called guardrails.
Guardrails
A guardrail in this sense is simply a number slightly above or below the 4% figure that would still work in light of newer information. For instance, Morningstar analysts say the subpar market returns that may be likely for the foreseeable future should pull the initial withdrawal figure back to only 3.7% of your retirement savings. And in 2024, Morningstar suggested that 55-year-old retirees would want to start out with an even lower initial distribution of 3.3% to better ensure their nest egg lasts the 40 years it will likely need to.
Separately but simultaneously, JPMorgan Chase says the 4% figure still has an 80% chance of working as hoped, but only with a 40% bonds/60% stocks portfolio, which will be at least a bit more volatile than a 50/50 allocation.
Then there are the guardrails above the presumed magic number. Bengen himself recalculated the figure back in 2021, ratcheting it up to 4.7% without adding significant risk to retirees who need 30 years' worth of retirement income from their portfolio. Number-crunching done by Guyton-Klinger suggests first-year withdrawals could safely be as much as 6.2% when the portfolio in question consists of 65% equities.
So, how do you know which of these guardrails is right for you? That's just it. You don't. In fact, the numbers will likely need to be changed on the fly when you encounter extraordinary circumstances (like a global pandemic). Rather than committing to a fixed plan that doesn't allow for adjustments, you're better served by being flexible around a proven premise, understanding that no statistical back-test can perfectly plan for every possibility.
That being said, figuring out any given year's correct guardrail may not be the most important concern for retirees, but particularly for early retirees.
Embrace the premise, but not mindlessly
All the studies above are based solely on statistical simulations, for the record. But they're good simulations, confirming that initial withdrawals ranging from 3.3% to as much as 6% of a 50/50 portfolio can and will work the vast majority of the time.
In most of the rare instances where the portfolio in question failed to last the full 30 (or 40 or 25) years of the simulation, however, you should know that the failure ultimately began in just the first few years of the time frame in question, with one very bad year.
For instance, brokerage firm Charles Schwab reports that in a test it ran in 2023, a 15% dip in its hypothetical portfolio's value during the first or second year in question would lead to a complete collapse of the portfolio within 18 years. That one sizable setback simply created a cascading effect that wouldn't become evident until several years down the road.
Conversely, a similar test performed by Morningstar just last year suggests that by simply avoiding big losses during the first five years of any simulation, the failure rate of its hypothetical portfolio was whittled down to a scant 1% by the 15th year.
The point is that avoiding any significant losses early in your retirement can make a huge difference later on. It may even be more important than figuring out the perfect percentage for your very first withdrawal from your retirement nest egg and all subsequent withdrawals. A healthy start will ultimately give you the flexibility needed to safely deviate somewhat from the 4% rule -- or any guardrail number discussed above -- in the future. And when it comes to investing, being able to adapt to an ever-changing backdrop is a pretty big deal.
Just err on the side of caution as you're making these decisions.
