A popular rule of thumb for retirees to determine how much money they can spend from their nest egg each year is known as the 4% rule.
It states that retirees can comfortably withdraw 4% of the total value of their investment portfolio in their first year of retirement. They should then increase that amount, by adjusting for inflation, every subsequent year.
By following this formula, seniors will likely have enough funds for a 30-year retirement period. The rule typically applies to a hypothetical portfolio invested 50% in stocks and 50% in bonds.
Why is the 4% rule useful for retirement planning?
With the 4% rule, you can estimate how much funds will be available for your spending needs each month based on the total amount you have when you retire. The adjustments for inflation are meant to help ensure you can maintain your standard of living over time.
For instance, if you retire with $1 million in funds, you can withdraw $40,000 in your first year of retirement. Going forward, you may withdraw $40,000 plus inflation annually. That means if overall consumer prices increase by 2% in the second year, you will withdraw $40,800.
The chart below shows another example based on a 4% withdrawal rate, comparing the outcomes of several scenarios: investing in a 100% stocks portfolio, investing in a 60% stocks and 40% bonds portfolio, leaving the money in Central Provident Fund (CPF) accounts to earn a guaranteed interest rate of 2.5% or 4%, or not investing at all.
While investing does bear some risk, it offers a very high success rate of lasting 30 years, and a much more significant median ending value to pass on to your loved ones.
The pitfalls of the 4% rule with inflation today
The 4% rule was developed by Bill Bengen back in 1994, using market returns between 1926 and 1976. In past decades, retirees had enjoyed low inflation and strong stock returns.
However, current market conditions in 2022 are now characterised by soaring inflation as well as lower projected equity and bond returns, making it unlikely for retirees to continue achieving investment returns matching those of the past.
In today’s inflationary environment, withdrawals will grow rather quickly, which means a retiree’s portfolio must earn higher returns to prevent the nest egg from being depleted too soon. At the same time, the ongoing market decline may result in portfolios falling in value, translating to smaller pools of money from which the retirees can withdraw.
These conditions are especially worrisome to those in their early years of retirement. Withdrawing too large a sum from the portfolio in the initial years, particularly when the value of the assets are also decreasing, can significantly increase the risk of running out of money later and disrupt the overall trajectory of retirement and retirement income.
Such concerns have thus sparked discussion over whether a 4% withdrawal will remain feasible for the coming decades.
Read more: Across older age groups, women tend to have far lower CPF account balances than men. Learn why.
Ways to update the 4% rule to retire well
The 4% rule can be a reasonable place for investors to start their retirement planning, but it should ideally be used as a basic guideline; not everyone needs to follow it strictly.
This is given the current challenging market conditions and several caveats that remain.
For one thing, in practice, the 4% rule can sometimes be too rigid. It assumes that we will never change our spending patterns throughout our entire retirement period. It also assumes our investment portfolio composition will always stay the same, and that the returns will rarely become negative.
Instead, retirees may wish to maintain some flexibility in their withdrawal strategy and review their spending rates annually, so that they are better able to respond to market or economic changes.
This may entail reducing their withdrawals after years of negative portfolio returns, and reverting to their normal amount once returns are positive again.
Morningstar has also said that a lower withdrawal rate of 3.3% for a 50-50 stocks and bonds portfolio could be more appropriate today, as its recent research indicated that the 4% rule may be a bit too aggressive.
Adopting a dynamic withdrawal strategy is another suggestion by the Morningstar researchers. One way to do this is to begin with a fixed withdrawal rate, but forgo the inflation adjustment in the year following a bear market, in order to preserve assets.
Another possible tweak to the 4% rule is called the guardrail strategy. This involves setting an initial withdrawal percentage, and then adjusting subsequent withdrawals annually within certain parameters based on the portfolio’s performance.
Asset allocation — or how you invest your portfolio — is important, too. If your portfolio has a bigger proportion of equities as compared to other asset classes, it will tend to support spending needs later in retirement due to the potential for growth in the long run.
Allocating some of the investments towards bonds and cash can provide stability and fund your expenses in the early retirement years. Diversifying further and adding some exposure to private credit and real estate may also help the portfolio withstand market downturns and inflationary pressures.
Next on the Endowus Fin.Lit Academy
Read the next article in the curriculum: Why is legacy planning important, and how is it done in Singapore?
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