Is the 4 Percent Rule Dead?
Over the past two weeks, we’ve discussed expected future returns for both stocks and bonds. Several experts feel the future results will be much lower than historical averages. So that makes us wonder, “Is the 4 percent rule dead?”
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Is the 4 Percent Rule Dead?
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Lower expected future returns for both stocks and bonds can affect your retirement. Many “experts” expect stocks to produce below-average returns over the next decade. They forecast somewhere in the neighborhood of 6.5% per year. They also expect lower returns from bonds—somewhere between 1 and 2 % per year.
Lower Future Returns and the 4 Percent Rule
If these lower returns happen, it can create a major challenge for retirees. If these predictions hold, a well-balanced portfolio would earn somewhere between 4% and 5% per year.
For the past 20 years or so, we’ve been big believers in the 4% rule for generating retirement income. This rules says you can take 4% of your retirement savings as income. So if you have a $500,000 nest egg, that translates to $20,000 per year or $1,666 per month.
Why Do We Believe in The 4 Percent Rule?
We use this guideline because it reduces the risk of running out of money during your lifetime. This has been back-tested during some of the biggest bear markets, and it has a high rate of success.
When you use historical return data, you can see why. Historical data shows a 60% stock-40% bond portfolio should grow by about 7% per year. So if you only take 4%, you would expect your account to grow by 3% per year. That’s enough to help your income grow each year to maintain your purchasing power.
What if Returns are Lower?
But what happens if the experts are right? What if those returns are less than average? Does the 4% rule still work?
In theory, if you earn at least 4% per year, you can take that much income and still maintain your principal. But there are a couple of things that come to mind. First, your odds of success will decrease a little. And, your ability to grow your principal to grow your income is also limited.
The second thing: what if you need to take more than 4% from your savings? A lower return environment going forward means you will increase the risk of running out of money during your lifetime.
Balancing Risk and Reward
Financial planners always talk about balancing risks and rewards. And the amount of income you take from your retirement savings is a perfect example. The 4% rule is simply a guideline to help you think about that risk. And even with lower returns expected in the future, it still has merit.
No matter what future returns are, one thing remains true. The higher your withdrawal rate, the more you risk running out of money. If you are unsure of how this impacts you, talk to a financial planner.
About the Author
Neal Watson is a Certified Financial Planner™ Professional and a Financial Advisor with Fleming Watson Financial Advisors. He specializes in helping hard working, middle class families plan for retirement.