High inflation could spell the end of the “4% rule” for retirees. The 4% rule for retirement has supported early retirees for the best part of a decade, that was during one of the longest bull market runs in history. The question is, can it survive this bear market, one characterised by stagflation.
The 4% rule has been the rule of thumb for retirees far and wide. This includes those in the F.I.R.E community such as Kristy Shen (Canada’s youngest ever retiree) to traditional retirees. That’s because the 4% rule dictates how much income they can safely withdrawal from their investment portfolios.
High inflation means the decades old rule for retirement may need further scrutiny. Might it break under the pressure of soaring inflation? Is it time to reassess your safe withdrawal rate or is it simply time to modify your retirement asset allocation. After all, you don’t want to run out of money.
Please note this is not financial advice and you are responsible for your own investment decisions. When investing capital is at risk.
What Is The 4% Rule For Retirement?
In 1994, William Bengen published a paper saying that retirees should start out withdrawing 4% of their assets annually, increase the distribution each year by the inflation rate and rebalance annually, and that their portfolio would last at least 30 years. Bengen’s research, became known as the 4% rule. At one point Bengen revised the rule and stated a safe withdrawal rate (SWR) could actually be as high at 4.5%.
The 4% rule is now one of the guiding principles of personal finance. Millions of retirees worldwide use it as a milestone for determining how much money they need to save for a long-lived retirement. This means that it’s not just retirees that stand to lose, but people aspiring to retire early.
Why Inflation May Cause The 4% Rule To Fail
The rule is simple, withdraw at 4% from your investment portfolio and there is a good chance you will never run out of money. You can then adjust this amount for inflation each year. The problem is, what happens when inflation hits 10%+. Can retirees continue to adjust for inflation or will they run out of money?
This problem is compounded by falling asset prices. Since the start of 2022 there has been no safe place to hide. Stocks, Bonds, Real Estate, Cryptocurrency has all fallen into a bear market. Therefore, whilst retirees should be reducing their spend, they’re having to increase it to cover the higher cost of living. All of which means that the risk of running out of money is increasing. This is because a retirement portfolio needs to be self-sustaining in order to maintain a retirees lifestyle.
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What Do Modern Economists Say About The 4% Rule For Retirement?
In an interview with Barron, Bengen has said he had slashed the equity allocation of his personal portfolio in half to 25%. This action was due to stocks having “extremely high valuations”. Nonetheless, he maintains that retirees will be able to keep pulling 4%-plus from their portfolios as long as inflation remains subdued.
The likes of Morningstar have also asked some tough question of the 4% rule. Concluding that a safe withdrawal rate of 3.5% is more realistic. Whilst another Barron interview with economist Wade Pfau, another influential specialist in retirement planning, argues a rate of 3% is a more realistic starting point. According to his estimates, the 4% rule now has only a 65%-70% chance of working out for new retirees.
Vanguard’s review of the 4% rule advises that retirees should actually reduce their safe withdrawal rate as the market and portfolio value falls. This is based on Vanguard research paper outlining a dynamic withdrawal method. Which states that that during market downturns retirees should reduce their withdrawal rate by a floor of 1.5%. Rather than withdrawing at 4% and even adjusting this with inflation, Vanguard’s research would suggest withdrawing at a rate of 2.5%. All of which makes it seem like the 4% rule is being rapidly eroded by new research.
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The 4% Rule For Retirement Vs Inflation
Until very recently, inflation trended around 2-3%, retirees in other eras have not been so lucky. Inflation averaged 7.4% per year in the 1970s and more than 5% per year in the 1980s. Both Begnen and other researchers will have covered these periods in as part of their 30 year coverage.
For example, Researchers Philip Cooley, Carl Hubbard, and Daniel Walz built on Bengen’s research in 1998. Their research paper “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable.” is famously known as “The Trinity Study,”.
The Trinity Study tested varying withdrawal rates on the different asset mixes over rolling historical time periods to determine success rates for each approach. The study generally corroborated Bengen’s findings, concluding that a 4% initial withdrawal on a 50% stock/50% bond portfolio exhibited a very high success rate over 30-year periods.
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The Trinity Study Vs Bengen: Choosing A Sustainable Safe Withdrawal Rate
An important distinction with Bengen vs the Trinity Study is the later incorporated different time frames and asset mixes. These asset mixes ranging from 100% equity to 100% fixed income. By contrast with Bengen’s research, which employed Treasury bonds for its fixed-income exposure, the Trinity study assumed high-quality corporate bonds. The reason this is interesting is because Treasury Bonds and other fixed income assets are making headlines in 2022.
Whilst retirees and aspiring retirees cannot control inflation, they can influence their asset allocation. Whilst the 4% rule covers economic periods of high inflation, this does not help retirees maintain income in the short to mid-term. There is also the perception of risk and the fear of running out of money to factor in. Especially for new retirees, who have just taken a huge hit to the value of their portfolio.
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Adapting The 4% Rule To High Inflation & Falling Asset Prices
Bengen’s research and that of the Trinity study both cover high inflationary periods. Following this both an asset allocation of stocks/bonds or Treasury notes had a high chance of portfolio survival. You can combine this with recent papers from the likes of Vanguard to encourage a more flexible approach to withdrawal of retirement income. Then you might be able to assume that the 4% rule +/- 1.5% is still a safe bet for the long-term.
The ship for retirees already invested in stocks and bonds has already sailed. Someone in the future who is planning to retire early, may wish to take a different approach. The problem is, what do you buy to maintain your portfolio value when almost every asset is falling?
Investors that can tolerate shock portfolio drops off over 20% can invest more aggressively and this can pay off in the long run. Retirees walking on finer margins might want to consider less volatile assets. Therefore it is a risk-reward equation. Those using the 4% rule for retirement will now need to consider how much volatility they can tolerate in retirement.
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How To Manage Income & Market Volatility In Retirement
Nouriel Roubini predicted the dot.com bubble, the 2008 financial crisis. He is the author of Crisis Economics, written in 2012 is I would argue predicts the current inflationary crisis. Having read this book it provides context for everything that is happening in the present day. Including the cost of living crisis and the superbubbles that have occurred in assets such as housing.
On a recent interview with CNBC, Roubini actually said what assets he would be buying.
Short term treasuries in rates and not price action of long bonds.
Treasury Inflation-Protected Securities (TIPS)
Gold and precious metal in China
I’ll let Roubini himself explain:
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Conclusion: Does The 4% Rule Have A Future?
Cash under the mattress is just going to disappear due to inflation. Whilst interest rates are improving and this encourages people to save, they still pale in comparison to inflation. When world leading economists encourage us to look at certain assets, then we probably should.
The 4% rule for retirement has been shown to be robust in periods of falling assets and high inflation. The current market conditions are eerily similar to those in the 70s characterised by high inflation, high debt and a weak fiscal position. However, the experts are all advising a degree of conservativeness when it comes to safe withdrawal rates. By extension of this, leading economists have highlighted further ways we can protect our portfolios and retirement incomes.
A diversified portfolio in the lead up to retirement and in retirement Is key. For those just starting out, then dollar-cost-averaging through this bear market can return a fortune once the bull market years return. They key is to have the right asset allocation for you. The problem is that there are so many individual indices and ETFs to review. The good news is, I’ve done the work for you.
Get My List Of 10 Inflation Protected Funds
My shortlist of 5 Defensive Retirement Style Funds.
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I don’t have a dog in the fight with only a 1% withdrawal rate filling all my retirement income needs but I also lived through the late seventies and early eighties and today’s inflation rate of 8% seems extremely mild to me. Plus 7% house mortgages, we’d have killed to get bargain rates like that when we bought our house, mortgage interest rates were over 10% back then. I think the fact that the safe withdrawal rate studies back test through some times when the economy was even more screwed up than it is today offer some comfort to those who are willing to follow the 4% rule. But it’s easy for me to say when I’m not one of them.