The 4% Retirement Rule Is Just a Starting Point

Ivanna Hampton: New retirees could kick off their golden years with a familiar number, 4%. A trio of Morningstar researchers analyzed starting safe withdrawal rates from an investment portfolio to fund retirement. The future looks good, and a little flexibility could make it even better. John Rekenthaler and his co-authors ran the numbers. The vice president of research for Morningstar Research Services is here to discuss what they found.

Thanks for being here, John.

John Rekenthaler: Yes, indeed.

The Rule of Thumb

Hampton: The big headline number from the latest report is a 4% initial withdrawal rate. Talk about why that number matters so much.

Rekenthaler: First, I’d like to talk about the irony of this because 4% historically has been the rule of thumb that people have used when thinking about how much money can I spend from my retirement portfolio. That 4% number assumes it’s 4% of your starting portfolio. So, you have a $500,000 portfolio, so 4% of that is $20,000 and you would spend that in year one. The next year you would spend the same amount adjusted by inflation. So, like as with Social Security, it would go up by the rate of inflation. So, $20,000 and if inflation is whatever, then it goes up to $21,000, say then $22,000. So, you’re keeping the same purchasing power. And 4% is based on some research from 30 years back. A fellow named Bill Bengen did some work and said this historically has always been a safe number, so that’s what I recommend.

Now we did thousands of simulations, a 70-page paper, and in this year’s edition, we exactly ended up matching the rule-of-thumb number. So, in a sense, all we did is, sort of, I guess you could say confirm what people already knew. But there’s a little more to it than that because we did plug in the current numbers that the stock and bond markets are at in making these projections. And we have done this study in the past and come up with different numbers. It just so happened that we ended up on a historic number this time.

And to finally get to your question of why is this important, well, I mean it’s just an estimate. But people only get one shot at retirement. And if you have a retirement portfolio, I think it’s important to try to spend the right amount of money. If you spend too much and you have the good fortune to live long, that could be a problem, right, if you’re running out of your assets and still alive. And you don’t really want to leave this world having regret that you spent too little and denied yourself the use of those moneys that you saved for retirement. It’s nice to be Goldilocks and try to find the rightsized chair.

Hampton: Or the perfect temperature of porridge, right?

Rekenthaler: We could continue with the Goldilocks analogy. But right, you don’t want ... what is it? Is it a baby bear’s chair that was right, I think? Mama bear’s? Anyway, let’s leave the fairy tales behind and go back to reality.

What Has Changed With Retirement Withdrawal Rates?

Hampton: The new rate is higher like you said. Morningstar’s suggested rate in 2022′s report was 3.8%. And then in 2021′s report, 3.3%. What has changed?

Rekenthaler: What has changed? The main thing is that bond yields are much higher than they were. If you remember back in 2020, yields on long government bonds reached as low as 1.0%. And at the time that we did this report, they were up about 4.5%. They’ve come down slightly since then. And since our portfolios, normally when you look at the portfolios, we do evaluate a mix of portfolios. But the portfolios that end up being most appropriate for most people have a balance of stocks and bonds. And they’re balanced portfolios. And they have a lot of bonds in there, and those are now making 4.0%, 4.5% instead of 1.0%. That’s the main factor. We also have a slightly more optimistic forecast for equities after the 2022 downturn. But that’s a smaller factor. So, basically, in our projections, because bond yields are higher, future returns will be higher on fixed income, and that will make for a somewhat higher spending rate.

Trade-Offs to a Conservative Start With Your Portfolio

Hampton: And you and your team call the base-case scenario conservative. The breakdown is 20% to 40% in stocks and the rest in cash and bonds. Can you talk about the trade-offs for a conservative start?

Rekenthaler: If you look at the math that we do, and we say what’s the highest withdrawal rate that portfolios can sustain, and it’s done over a 30-year period, and we run a lot of trials and simulations using the assumptions on the markets and so forth. You end up with these relatively conservative portfolios of 20% to 40% in equities. It’s important to note, though—and if you read through the report, you can see it all, but we’re just talking the highlights here—It’s important to note that if somebody has 60% or 70% in stocks, the withdrawal rate, the safe withdrawal rate figure that we come up with is almost the same. It’s 3.8% or 3.9% instead of 4.0%. So, there’s a slightly lower probability of success, I guess you could say, or it’s slightly riskier. But there’s a lot of reason to be more aggressive because in most cases, under most conditions because we’re looking at worst-case scenarios. Under most conditions, when you have a 60% or 70% equity portfolio, you can end up with more money over time. There’s a good chance you’ll even grow that nest egg rather than cut into it with your spending. So, it’s certainly something that people should consider. That’s a starting point. That’s why we call it a base case.

Our view is we hope that people at least look at the highlights of this report and think through the details because one size does not fit all in retirement by any means. I mean, people’s personal conditions are different, their life expectancies are different, their tastes for risk are different, their spending patterns, and so forth. So, it’s important to understand we need to come up with some numbers as a starting point, that’s what that 4% number is, but that is not the ending point.

Hampton: You got to do some self-reflection.

Rekenthaler: You got to do self-reflection and customize them. Again, this is somebody’s life. So, spend a little time on it and think about it.

Risks and Benefits of Changing a Portfolio’s Stock Allocation

Hampton: Now the safe withdrawal rate dips if a portfolio’s stock allocation changes, like you just mentioned. Explain why and the potential risk and benefit.

Rekenthaler: Basically, the way that math works is if you add more equities to a portfolio, more stocks to a portfolio, it becomes more volatile. On average, over time, it will make more money. So, under most conditions, as I had said, you’re going to be better off adding more equities. But if the markets are unfavorable, particularly over a prolonged bear market, say a two-, three-, four-year bear market, and that pool of capital is shrinking, and then you’re pulling out money each year from a declining pool of capital, that’s where investors can run into trouble. That can get to be a point where, as you’re removing money from investments that are losing value, that portfolio gets so small that it can’t really come back. The reason it can’t come back is because you need to spend from it. It doesn’t get a break. If you’re saving for retirement and you just set those moneys aside, if there’s a bear market and then the bull market comes back, you’re going to bounce back. But when you’re pulling money out and withdrawing money from a portfolio, the ability to sustain a bear market, it’s not the same. It’s much harder to sustain a bear market. That’s why the math for these kinds of studies is different than when saving for retirement. It’s more complicated when people are withdrawing. Unfortunately, retirement is the most complicated financial situation, and it’s one where you can least afford to make a mistake because you don’t have time to go back and redo it. That’s the challenge associated with planning in retirement.

Flexible Spending Strategies

Hampton: Then the report also looked at different spending strategies. Which would allow a retiree who is flexible to spend more than 4% and not run out of money?

Rekenthaler: Actually, there are a number of flexible strategies. Again, we have used the word conservative a couple of times. Our study is conservative. We don’t want people to make, not a mistake, but if they do, to err on the side of caution, rather than overspend. So, the 4% number that we came up with, the assumption is that the person is locked into that same spending pattern every year. They never change. Even if the markets perform very badly, they still take the same amount out the next year. In reality, that’s not really what people would do. At least I would hope not. You make contingency plans, and things are going well, maybe you spend some more. If things are going unusually poorly and your portfolio is shrinking, you’d be a little bit more careful. We have some rules, various systems. One is called guardrails. There’s another one where if there’s a downturn in the market, you spend less the next year. There are various systems in there that are flexible, and they permit higher spending rates, often up to 4.5% to 5.0% withdrawal rates even. People have control over their fortunes. You set up this base case, but it doesn’t mean that they have to behave that way. The good news is that what we have in our report is really a starting point. And people can, I think in most cases will be able, to do better than what we’re saying. So, I think what we’re saying is—and in fact, I know what we’re saying, not just think—is consider 4% your starting point in retirement, then look through the circumstances and try to find ways, you could probably safely get 4.5% or 5.0% by being flexible and just tinkering with the strategy a little bit.

Hampton: Can you quickly explain what guardrails are?

Rekenthaler: Guardrails is just ... not really. Well, the very quick version with the guardrails is when the markets are doing well, you spend more money and when the markets are doing poorly, you spend less money. So, that’s why it’s called guardrail. It’s seeing how your portfolio is doing and making adjustments, and it keeps you from spending too much when times are bad but does give you a raise when times are going well.

Hampton: That was a great explanation.

Rekenthaler: I guess.

The Role of Guaranteed Income

Hampton: Let’s talk about the role of guaranteed income like Social Security. How can these income sources bolster retirement spending?

Rekenthaler: The more guaranteed income that an investor has, the more risk they can afford to take with their nonguaranteed income, that is with their investment portfolios. Primarily in this paper, when we’re talking about a 4% withdrawal rate, we’re talking about investment portfolios. We’re talking about what are customarily called risky assets. So, some sort of portfolio of stocks and bonds, not a pension, not Social Security, not an annuity. Those are all guaranteed sources of income. So, the higher the guaranteed source of income and the more that they—ideally guaranteed sources of income—would completely fill an investor’s or a retiree’s necessary spending, their required spending, and then the investment assets would cover the discretionary spending. So, it’s really, in a sense, house money.

So those portfolios, if there’s a high degree of guaranteed income, we would say you probably wouldn’t want to just do 20% to 40% equity. You’d probably want to have a higher position in equities. And yes, technically, the withdrawal rate that we come up with is slightly lower, but you’re protected with this guaranteed income. So, you don’t have that same need as somebody who is primarily living on their investment pool. So again, I had talked about the individuality or how this is an individual and personal choice depending on circumstances. The amount of guaranteed income that somebody has is definitely an important factor to look at when setting up a strategy. Somebody has a small amount of Social Security versus a rather large Social Security plus maybe a pension associated with their business, those are people in very different positions.

Key Takeaways

Hampton: And as we wrap up this conversation, the key takeaway, what do you want us to walk away with?

Rekenthaler: The key takeaway is, I think, understand the starting point of about 4%, be flexible, monitor year by year, and you’re not stuck into a lifetime plan, but you need to have a starting point. You need to start somewhere, and we think we’ve provided the appropriate starting point.

Hampton: Thank you, John, for your time today.

Rekenthaler: Glad to be here, Ivanna.

Hampton: That wraps up this week’s episode. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to senior video producer Jake VanKersen. And thank you for watching Investing Insights. I’m Ivanna Hampton, a lead multimedia editor at Morningstar. Take care.