Financial professionals have long relied on the 4% rule as a prudent starting point for withdrawals in the first year of retirement. In a follow-up to his recent podcast episode on the topic, Retirement Director Ben Rizzuto explains why factors such as current market valuations and inflation have called this approach into question and explores potential solutions for today’s retirees.

In a recent podcast episode, I discussed the 4% rule and shared some ideas about how much retirees can withdraw on an annual basis. With this post, I wanted to go into a bit more depth by reviewing some research and providing a few visuals to help illustrate this topic.

All retirees grapple with the question of how much they can withdraw from their investment accounts on an annual basis to meet their retirement expenses and enjoy the assets they’ve accumulated. The answer to this question presents a classic Goldilocks scenario: Withdraw too much and you run the risk of running out of money before the end of retirement; withdraw too little and you leave money on the table and may inadvertently limit your level of enjoyment in retirement.

Example:

• Account balance = $500,000
• First year withdrawal = $20,000 ($500,000 x 4%)
• Second year withdrawal = $20,000 + 2.5%* = $20,500
• Third year withdrawal = $20,500 + 2.5%* = $21,013

*Assumed inflation rate

So, What’s the “Right” Withdrawal Rate?

All these conflicting opinions certainly don’t help today’s investors understand how they should approach their retirement withdrawals. The fact that we continue to use the word “rule” when discussing these ideas isn’t helpful either. But while I would love to be able to provide one number that works for everyone, I can’t. That’s because there is no “right” answer for everyone. Like many things in this life, it depends. Each investor’s situation is different, so every individual’s withdrawal percentage is going to be different as well.

Now, that is not to say that these “rules” should be completely discounted. However, I do feel that they should be viewed as well-informed starting points rather than hard-and-fast rules. How can retirees best use these starting points to suit their unique circumstances, needs and goals? Two of the main variables to consider are market valuations and inflation.

Put Simply (and Somewhat Morbidly), You Want to Die with $1

One of my favorite pieces of research on this topic comes from Michael Kitces. In 2008, he looked at rolling 30-year periods using a 60/40 portfolio to identify how much an investor could withdraw in year one of retirement, inflation adjusted so that, at the end of a 30-year period, the residual balance would be exactly $1. As you can see below, the percentage is going to depend entirely on when the withdrawals started. There are years in which that initial withdrawal rate could have been 8%, 9% or even 10%. And there are years in which the initial withdrawal rate would have been much more modest.

Source: The Kitces Report, “Resolving the Paradox – Is the Safe Withdrawal Rate Sometimes Too Safe?” May 2008.

The really interesting bit is that Kitces then compared those withdrawal rates to the Shiller Cyclically Adjusted PE Ratio (CAPE Ratio). This ratio takes into account stock prices over the 10-year average of earnings, adjusted for inflation, and gives us a more refined Price/Earnings ratio compared to just looking at the trailing 12 months or the forward-looking 12 months of earnings.

Kitces found that the historical correlation was negative 0.74.⁴ This means that when the Shiller CAPE is high, the safe withdrawal rate for the next 30 years tends to be low, and vice versa.

You may be wondering, where is the Shiller CAPE currently? As shown in the chart below, as of January 4, 2022, it is at just over 40 – a level only seen twice before, first preceding the Great Depression and then in 2000 before the dot-com crash.⁵ This relatively high level indicates that a lower withdrawal rate may be warranted.

Source: multpl.com/shiller-pe, January 4, 2022.

What Goes Up…

The reason retirees may want to consider a lower withdrawal rate is that current market valuations are relatively high, meaning those valuations – and the markets – may be due to decline sometime in the not-so-distant future. This intuitively makes sense: When market values are higher, there tends to be a higher probability for a correction. And we know that one of the things that will destroy a withdrawal rate is a substantial loss in the first few years of retirement.

The idea, referred to as sequence of return risk, particularly affects retirees in their first five to seven years of retirement, since it will decrease the value of their assets and impact the overall trajectory of their retirements.

In other words, if you experience negative returns early on in retirement and are taking a higher withdrawal rate that will increase annually based on inflation, your assets simply will not last as long.

Inflation: The Elephant in the Room

Past research on retirement withdrawal rates has used an assumed inflation rate of 2.2%. While this may be historically accurate, we all know that inflation is currently much higher, ranging from 5.0% to 6.8% over the past few months. This is a key consideration because inflation serves to magnify certain issues within a portfolio.

To illustrate, Bengen provided a great analogy in a recent article, likening a retirement portfolio to a balloon with two opposing holes. On one end is the portfolio returns hole that helps inflate the balloon. On the other end is the withdrawals hole that deflates the balloon. Inflation increases withdrawals and then locks them in at higher levels, allowing more air to escape.⁶ So even if inflation is transitory, it will place your withdrawal rate at a higher overall level.

Bengen has updated his research to account for inflation and provides some suggested withdrawal guidelines for both low-deflation and high-inflation regimes, as shown below.

Source: Bengen, W. “Bill Bengen Revisits The 4% Rule Using Shiller’s CAPE Ratio, Michael Kitces’s Research.” Financial Advisor, December 2020.

What’s the Solution?

So, what does all this mean for today’s retirees? While the specific percentages vary, we can all agree that the market is at a relatively high point. Based on both the current level of inflation and the CAPE ratio, it would seem prudent for those who are entering retirement now to start with a lower withdrawal rate. Remember, large portfolio loses in the first few years of retirement can significantly change (for the worse) the trajectory of one’s retirement and retirement income.

While clients may not want to start with a low withdrawal rate, it is important to remind them that things can change. To expect everything to stay exactly the same – withdrawal rate included – from the start of your retirement through the next 30 or more years is not realistic. We have all experienced years where the markets do better, or the markets tank, or inflation is low, or expenses are higher, or income is lower. And throughout all those periods, we have made changes, whether that means cutting back on spending or taking gains after a good year. And that is precisely why the 4% (or 4.7% or 3.3%) rule should not be thought of as a “rule”: because as soon as changes occur, that rule may need to be broken.

Put another way, while the 4% rule may work on average, we do not live our lives based on an average. Our financial lives are singular to us, so using a rule or average may not be useful for our specific situation. This is why it’s important to sit down at your kitchen table or with your financial professional and consider your assets, expenses and budget in retirement, as well as how factors such as medical expenses, taxes and your goals will change over time.

Again, I would encourage retirees to think of the 4% rule as a starting point. From there, it may make sense to consider ways to supplement your income in retirement. For example, laddered bonds, dividend paying stocks and other types of investments can help increase the yield and total return generated within your portfolio, all of which can help grow your assets so you can increase your withdrawal rate. Along with that, annuities offer a number of ways to participate in the market while potentially limiting downside exposure and generating a stable stream of income.

Finally, remember that your withdrawal strategy comes down to a few key variables:  The size of your portfolio, the returns (both capital appreciation and yield) of your investments, the direction of the market and your allocation to those assets, and inflation.

Many of those variables will change over time, which means your withdrawal rate may have to change as well. Thus the only rule we can really depend on is that change is inevitable, and we must be prepared to respond accordingly.

 

¹ “Resolving the Paradox – Is the Safe Withdrawal Rate Sometimes Too Safe?” The Kitces Report, May 2008.
² “This Metric Signals Weak Returns For U.S. Stocks From 2022” Forbes, December 26, 2021.
³ W. Bengen, “Determining Withdrawal Rates using Historical Data.” Journal of Financial Planning, October 1994.
⁴ “The State of Retirement Income: Safe Withdrawal Rates.” Morningstar, November 2021.
⁵ W. Bengen, “Is It Now the ‘3.3% Rule’?” Advisor Perspectives, November 2021.
⁶ Bengen, W. “Bill Bengen Revisits The 4% Rule Using Shiller’s CAPE Ratio, Michael Kitces’s Research.” Financial Advisor, December 2020.