Experts say the 4% rule, a popular retirement income strategy, is outdated

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  • According to a paper published Thursday in Morningstar, the 4% rule, a popular strategy for measuring withdrawals from one’s retirement portfolio, won’t work as well in the coming decades due to under-estimated stock and bond returns.
  • Instead the withdrawal rate should be 3.3%, the paper said. This can have a huge financial impact on retirees.
  • However, there are several caveats. Retirees are likely to have other pots of money, such as Social Security, to take advantage of, and can adjust spending according to market conditions.

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Market conditions are pressing the 4% rule, a popular rule of thumb for retirees to determine how much money they can live off each year without fear of running out later.

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Taking money out of your nest egg is one of the most complicated financial exercises for households. There are many unknowns – the length of retirement, one’s spending needs (health costs, for example) and investment returns, to name a few.

The 4% rule is meant to achieve a consistent stream of annual income, and provides seniors with a high degree of comfort that their wealth will last until 30 years of retirement.

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Simply put, the rule states that retirees can withdraw 4% of the total value of their investment portfolio in the first year of retirement. The dollar amount increases with inflation (cost of living) the following year, as will the next year, and so on.

However, market conditions — that is, lower projected returns for stocks and bonds — aren’t working in retirees’ favor.

Given market expectations, the 4% rule for senior citizens “may no longer be possible”, according to a paper Published Thursday by Morningstar researchers. These days, the 4% rule should really be the 3.3% rule, he said.

Although the deduction may seem small, it can have a big impact on retirees’ living standards.

For example, using the 4% rule, an investor would be able to withdraw $40,000 from a $1 million portfolio in the first year of retirement. However, using the 3% rule, the first year withdrawal drops to $33,000.

According to a CNBC analysis, the difference will be more pronounced in later retirement, when accounting for inflation: $75,399 versus $62,205, respectively, in the 30th year. (The analysis showed a 2.21% annual rate of inflation, the average estimated by Morningstar over the next three decades.)

Why 3.3%?

According to Christine Benz, director of personal finance and retirement planning at Morningstar and co-author of the new report, retirees have enjoyed a “trifecta” of positive market growth over the past several decades.

He added that low inflation, low bond yields (which pushed up bond prices) and strong stock returns have helped accelerate the uptick in investment portfolios and safe exit rates.

Benz said the dynamic may have nearly lulled retirees into a false sense of security.

According to the report, the bonds are “highly unlikely to enjoy strong gains over the next 30 years,” and are likely to decline higher stock prices as they return to average. The analysis assumes that this outcome is probably not inevitable.

(Although inflation has been historically high in recent months, Morningstar expects it to ease over the long term.)

Investment returns are especially important in the early years of retirement because of so-called return-of-return risk. Withdrawing too much from your nest egg in the first year or so—especially from a portfolio that is declining in value at the same time—can greatly increase the risk of running out of money later.

This is because there is less runway for the portfolio to grow after the investment rebounds.


Of course, there are enough caveats to this analysis of the 4% rule.

For one, the 4% rule (and the updated 3.3% rule) only considers one’s portfolio investments. It does not account for non-portfolio income sources such as Social Security or pensions.

For example, retirees who delay claiming Social Security until age 70 will receive a higher guaranteed monthly income stream and may not need to rely as much on their investments.

Furthermore, the rule of thumb uses conservative assumptions. For example, it uses a 90% probability that senior citizens will no longer have money after 30 years of retirement.

Comfortably retirees with more risk (i.e., less chance of success) or who think they won’t live into their 90s may be able to safely withdraw large amounts of money each year. (A 65 year old today would be Live Another 20 years, on average.)

Perhaps most importantly, the rule assumes that one’s expenses do not adjust according to market conditions. But that may not be a reasonable assumption — research shows that seniors typically see their spending fluctuate through retirement.

According to Morningstar, retirees have a few options in this regard to ensure the longevity of their investments. Generally, these call for lower withdrawals after years of negative portfolio returns.

For example, retirees can skip inflation adjustments in those years; They can also choose to reduce their normal withdrawals by 10%, and return to normal once investment returns are positive again.

“There are some simple tweaks you can do,” Benz said. “It’s not one giant strategy; it could be a series of these incremental changes that can make a difference.”

However, there are tradeoffs for being flexible. Primarily, these annual adjustments to spending can mean large fluctuations in one’s standard of living from year to year.


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