Worried about your shrinking nest egg? How the 4% rule can help save your retirement

Say you retired a few months ago when stocks were flying high. You probably felt pretty comfortable taking a healthy flow of cash from your portfolio to support your lifestyle.

Then the coronavirus crisis hit and stocks tanked. How do you determine if the rate of your withdrawals is now too high to be sustained by your diminished portfolio?

To assess where you stand, it makes sense to measure the withdrawals from your portfolio against a metric known as the 4 per cent sustainable withdrawal rate (also called the “safe” withdrawal rate, or the “4 per cent rule”).

While no withdrawal rate is foolproof or guaranteed, this one provides a rough and reasonable measuring stick that is widely used and has stood the test of time going back to the 1920s. So it’s worked through the Great Depression, the double-digit inflation of the 1970s, and repeated bear markets, some of which were far worse than what we’ve experienced so far in this market meltdown.

This is how the 4 per cent sustainable withdrawal rate works as commonly used when built into a retirement plan: If you retire at age 65 with a balanced stock and fixed income portfolio, you can annually withdraw 4 per cent of the initial amount in your portfolio when you retire, plus subsequent inflation adjustments, with little risk of outliving your money.

So if you retired at age 65 with a balanced portfolio of $ 500,000, you could withdraw 4 per cent, or $ 20,000, in the first year. If inflation is 2 per cent, then you could withdraw $ 20,400 in the second year ($ 20,000 plus 2 per cent), with further inflation adjustments in each subsequent year. That way you’re able to maintain a constant standard of living.

But the metric can also be used a bit differently as a rough test to the sustainability of ongoing withdrawals that you have already established. In this case, apply the 4 per cent sustainable withdrawal rate to your portfolio balance just before the market meltdown started. (Balances from your December or January statements should do.) Assuming you’re fairly close to age 65 and using the same example of a $ 500,000 portfolio, then that justifies the same 4 per cent withdrawals of $ 20,000 a year or $ 1,670 a month. If you are drawing roughly at that rate or less, then this test tells you that your withdrawals should still be sustainable despite the market meltdown.

The reason you apply the test to your portfolio before the meltdown is that the 4 per cent rate is set deliberately low to protect you in the most challenging situations, such as if you retire and start withdrawing money just before a big market crash like the one that just happened. If you instead apply the 4 per cent sustainable withdrawal rate to your diminished portfolio balance as it is now, you calculate a lower withdrawal figure which is probably more restrictive than is necessary.

The 4 per cent sustainable withdrawal rate has stood the test of time based on extensive historical research. This research established that retirees investing in a balanced portfolio of stocks and high-quality bonds that earned market returns would have been able to sustain withdrawals at around the 4 per cent level for any 30-year period since the 1920s without running out of money. So someone retiring at age 65 would have been able to withdraw at that rate until at least age 95.

U.S. financial planner William Bengen conducted the original U.S. research that established this metric in the early 1990s. Subsequent research has found broadly similar results after updating it to cover more recent years, expanding the scope to other countries including Canada, and tweaking many of the assumptions. While 4 per cent continues to be the most widely used rate, some studies have come up with a figure that is a bit lower or a bit higher. Bengen himself eventually settled on a 4.5 per cent sustainable withdrawal rate.

But it is important to understand that the sustainability of this rate is never totally certain. While it has so far stood the test of a long swath of history, past results do not guarantee future performance. Also, you might live longer than age 95. So it should inspire some confidence, but it pays to be a bit cautious as well.

Consider Bengen’s advice: “It’s natural for people to be fearful in bear markets and I expect this bear market is not over,” Bengen told me in an interview last week. “History is on their side that a (4 per cent or) 4.5 per cent rate will probably get them through, although they do need to monitor it.”

If your finances are a bit tight and you want to play it safe, cut back discretionary spending. “You don’t have to spend at the rate you were expecting,” says Bengen, who is now retired from providing advice to clients but continues to do research. “Pull your ears in for a year or two. Reduce the strain on your portfolio due to withdrawals. That will give you an extra measure of comfort. Most people do that naturally, anyway.”

The sustainable withdrawal rate is designed to protect you in the event of a near worst-case scenario. During the worst investing periods, the 4 per cent to 4.5 per cent rate would have lasted the full 30 years, but just barely, with little or no money left at the end. However, in the more likely scenario that you enjoyed average returns or better, you would have been able to increase your withdrawals or leave a sizable bequest to your heirs.

Encountering a bear market soon after you retire presents the toughest challenge. “That’s been shown throughout history,” Bengen says. The experts refer to this as sequence of returns risk. If the bear market you encounter early in retirement is severe and lasts for a lengthy period, your need for withdrawals may cause you to keep selling stocks at beaten-down prices. That, in turn, may result in your portfolio being too diminished to benefit much when stock prices eventually recover.

According to Bengen’s research covering data going back to the mid-1920s, the worst moment to retire was late 1968/early 1969. Those retirees were hit hard by two bear markets and double-digit inflation within the next decade.

Another challenging time to retire was 2000, just before the tech boom collapsed. While those retirees still have another decade to go before 30 years is reached, they appear to be on track to make it through at the 4.5 per cent sustainable withdrawal rate despite a poor investing climate, Bengen says. “The 2000 investor is the only one that has encountered two very large bear markets early in retirement of 50 per cent or more and they seem to be doing OK.”

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In my view, the sustainable withdrawal rate at around 4 per cent is a good, general, middle-of-the-road number that works well for many people. Use it as a starting point and consider possible adjustments if you want a more precise figure tailored to your situation and preferences. That greater precision may be important to you if, for example, you’re preparing a detailed financial plan. Depending on what individual factors apply, I believe most people should find withdrawal rates within a range of roughly 3 per cent to 5 per cent sustainable if they retire fairly close to age 65.

Here are factors that may cause you to push your sustainable withdrawal rate a little higher: if you have good backup assets (such as equity in a paid-for home and/or a cottage) that you are prepared to tap late in retirement if necessary, or you have substantial discretionary expenses that you’re prepared to cut if you have to, or if you retire much later than 65 (because the money doesn’t have to last quite as long), or if you’re a “live (and spend) for today” kind of person.

There are other factors that may cause you to reduce your sustainable withdrawal rate a bit: if you’re a renter who lacks backup assets; if you’re not able or willing to be flexible about your spending; if you’re not confident of your ability to manage your investments effectively; if you just want to play it safer; or if you retire much earlier than 65 (because you need to stretch your withdrawals over a longer retirement). As an adjustment for early retirement, I suggest reducing the withdrawal rate that you would otherwise use by about 0.1 a year if you retire between ages 60 and 65.

David Aston
David Aston, a freelance contributing columnist for the Star, is a personal finance and investment journalist. He has an M.A. in economics and is a Chartered Professional Accountant. Reach him via email: davidastonstar@gmail.com