How much money do I need in retirement? A question that would be simple to answer if not for one inconvenient nuance of retirement planning – the fact that nobody knows how long it will last. This lack of insight into our own mortality has led to the widespread adoption of the 4% rule.

The 4% rule is the basis of retirement plans across the world, heralded as a ‘safe’ withdrawal rate from your portfolio. A few simple calculations and the 4% withdrawal rate leads to the magic number that is the lump sum you need in retirement. Voila.

The history of the 4% rule

The 4% rule is the basis of the retirement plans across the world, heralded as a ‘safe’ withdrawal rate from your portfolio. It originated when US financial adviser Bill Bengen conducted a study to understand how much his clients could take out of their portfolios without running out of money.

Bengen, knew that the biggest issue facing people approaching or early in retirement was the sequencing of returns. A bear market during those early periods can have significant adverse effects on retirement outcomes – especially in early retirement where money is being withdrawn from your account. In times of falling markets, taking money out of your account to pay for your expenses means you don’t have time to save and invest to make up for poor returns. This means that it is difficult to make up for the up for the poor returns you received early in retirement.

Knowing this risk, Bill naturally started his analysis by looking at the three biggest stock market declines up to that point – the 1929 to 1931 bear market where the market fell 61%, the 1937 to 1941 bear market where the market fell 33% and the 1973-1974 bear market where it fell 37%.

He looked at what would happen if someone retired every year since 1926, and what the outcome would be based on different withdrawal rates (the money withdrawn from retirement accounts each year – usually conveyed as a percentage). The analysis showed the impact of different sequences of return – all of the return outcomes differed from each other.

Bill was targeting a fixed real withdrawal for his simulations, and his goal was to identify the starting withdrawal percentage, with that initial dollar amount adjusted thereafter for inflation, that would have supported payouts over previous historical periods, even if the retiree had the misfortune of retiring into the worst conceivable market environment.

The portfolio that he used in these simulations was invested 50% into stocks, and 50% into bonds. Incorporating asset-class performance over rolling 30-year periods since 1926, he found that a 3% withdrawal rate gave you a portfolio that would last 50 years. In other words, you could safely fund a retirement without running out of money for 50 years, even if you had the misfortune to retire during a bear market.

This was too conservative for many investors who would not live long enough for a 50 year retirement. When he looked at a 4% withdrawal rate, he found that your portfolio would last 30 years - and that in no period in the history of the stock market would anyone run out of money in less than 30 years - no matter when they retired. That was the birth of the 4% rule.

 

How it works and why it matters for investors

This withdrawal rate matters when you are setting goals for your retirement.
To calculate how much you need in your portfolio you simply divide the amount of money you would like per year by this withdrawal rate. If you want $100k per year to be generated from your portfolio at a 4% withdrawal rate you can divide $100k by 4% which equals $2.5m.

This number isn’t just valuable because it provides a goal post, but also because it provides investors a way of estimating the amount needed for retirement even if it is several decades away and can seem abstract. It may be hard to picture what a $1 million retirement portfolio means, but it is easy to imagine what a $40,000 a year income means. In this way the 4% rule is useful for all investors and not just for pre-retirees and retirees.

If we enter a $1 million retirement goal into Morningstar Investor’s goal calculator, it shows that an investor with 40 years left has a minimum required rate of return of 6.1% (given a starting value of $1,000, additional investments of $15,000 and accounting for inflation). This is the return that your investments need to generate each year to get to your goal retirement of withdrawing $40,000 a year.

The calculator allows investors to adjust the variables that go into goal setting: time horizon, additional investments, your end and starting balance. If we adjusted the scenario to see what an investor would need with fifteen years left, we would have a significantly higher required rate of return. The calculator gives you a warning that historically, this is a return that is too aggressive.

Understanding this lump sum amount that is needed using the withdrawal rate helps with goals-based retirement planning. Naturally, the more time that an investor has, the more their portfolio can compound. In this way, the withdrawal rate and the 4% rule can help even investors just starting out to estimate their retirement needs.

There are a few nuances to the 4% rule.

Inflation

Bill Bengen’s model allows you to take out 4% of your assets to live off in your first year of retirement. If you have $1 million, you would be able to take out $40,000. The first nuance that many investors often forget is that the model allows for inflation in each subsequent year’s withdrawal. If we used the same figures, if you experienced a 2% inflation rate in you first year, you would withdraw $40,800 in your second.

Life expectancy

Another caveat is that the 4% rule accounts for a retirement period of 30 years. As life expectancy has increased, the period that investors must provide for themselves in retirement has also increased. In more cases than not, many people are experiencing retirements as long as their working lives. It’s important to understand that this shift has consequences – the entire purpose of the 4% rule was ensuring that you do not run out of money in retirement. If thirty years becomes the exception and not the rule for younger investors, we must question whether it is time to make adjustments.

Spending

Bengen also assumes a static spending amount in retirement. We know, through research, and experience, that this is not the case for retirees. Generally, retirees tend to spend more at the beginning of retirement, with spending decreasing as time continues, and then spiking at the end due to end of life costs. The amounts withdrawn with the 4% rule do not account for these varied expenditures, as withdrawals in the model are static.

Tax

The 4% rule does not take into consideration tax. In Australia, we are lucky to have a strong superannuation system. In retirement, your pension account is tax-free (up to $1.9 million). Be aware that superannuation earnings above this will incur tax, and any earnings in non-superannuation accounts will be taxed at marginal tax rates.

Housing

How to think about hosing in an investment context is front of mind for a lot of investors. As with all factors in investing, your individual circumstances will vary. Investors generally estimate their retirement needs by using a replacement rate. A replacement rate is used to find the rate at which you need to replace your salary, and it’s done by estimating your retirement living expenses after savings and taxes. Housing is a large expense, and some Australian studies indicate that on average around 25% of income is spent on a mortgage in a dual income household.

If you are the average Australian household and you have paid off your house, you can effectively reduce your replacement rate by 25%. That smaller replacement rate translates into a smaller lump sum to support your retirement. We can still use the 4% rule to demonstrate the impact. If you are looking to withdrawal $75,000 a year out of your portfolio you need $1.875m. If you subtract 25% from the $75,000 that means a total withdrawal of $56,000 which reduces the portfolio value to $1.4m.

In this example, owning your own home reduces the amount that you need in retirement by $475,000. Paying off your home can have a large impact but retiring when still paying your mortgage leaves you will little way to use that asset to fund your retirement with selling your house or borrowing against it.

Aged-based pension

Another impact on the replacement rate is other sources of income in retirement such as the aged pension. The aged pension is eligible to all Australian residents that meet the income criteria and asset tests.

It is important to note that pensions have been and will be subject to policy change. The eligibility criteria, amount paid and the age it is paid at is not a guarantee, especially for those with longer time horizons.

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