For decades, workers planning for retirement have used a simple rule to determine whether they had enough money set aside to retire. The so-called 4% rule led to a very simple mathematical conclusion: As long as you had 25 times the amount you expected to need for living expenses in your first year of retirement, then you had a very high probability of having your money last long enough to support you for the rest of your life.
Unfortunately, simple guidelines like the 4% rule aren’t designed to handle extraordinary conditions in the financial markets. The conclusion of a recent research paper examining safe withdrawal rates from retirement accounts is that with bond yields at extraordinary low levels that are insufficient to cover the impact of inflation, using the 4% rule introduces far more risk than you can afford to take.
At the end of this article, I’ll give you some strategies you can follow to preserve your retirement nest egg even under tough conditions like these. First, though, let’s take a closer look at the reason that the 4% rule is in danger of failing investors, at least right now.
Professors Michael Finke and Wade Pfau joined Morningstar retirement expert David Blanchett in publishing a working paper aptly called “The 4 Percent Rule Is Not Safe in a Low-Yield World.” The paper noted that under ordinary circumstances, following the 4% rule has historically led to a success rate of about 94% in helping retirees outlive their money.
Typically, the 4% rule assumes that retirement investors will split their portfolios between stocks and bonds. The stock portion of the portfolio ensures some modest level of growth to handle the rising inflation-adjusted withdrawals that the rule calls for in future years, while the bond portion is intended to provide a substantial part of the current income that retirees withdraw from their nest eggs.
The problem right now, though, is that retirees’ bond portfolios aren’t pulling their weight. The iShares Core Total US Bond Market ETF , for instance, yields just 2.5%, not coming even close to providing its share of cash for retirees to withdraw under the 4% rule. Even when you boost your time horizon, iShares Barclays 20+ Year Treasury fails to get you to the 3% level. Meanwhile, those seeking inflation protection via iShares Barclays TIPS Bond Fund (ETF) (NYSEARCA:TIP)or similar investments are earning even lower returns, with negative real rates after inflation on TIPS of -1% as far out as 2020 and below zero extending 15 years into the future.
The paper concludes that if low real rates persist, then the chance of failure rises from 6% to 57%. Moreover, even if real rates revert to more normal conditions within five to 10 years, failure rates remain substantially higher, leaving retirees’ prospects at risk.
What to do
How investors should handle this challenge depends on your situation. If you’re still working and have time to save more, then adopting a lower withdrawal rate boosts your chances of success. Blanchett argues that a 3% withdrawal rate is a better starting point from a sustainability standpoint, although it requires you to boost your overall nest egg target by a third, to 33 times your expected annual income needs. That’s a bit much for most people to make up in a short period of time.