The global financial crisis and other recent market developments raise questions over the validity of the 4% withdrawal guideline for retirement funds.
For most investors, living off of dividends and interest income alone won’t be enough to cover their desired lifestyle needs in retirement. Many will need to draw down their assets over time to generate enough cash flow. The key is to withdraw enough each year to meet your spending needs without drawing down too much and potentially running out of money too soon.
Those concerned over making their nest egg last looked to the 4% Rule as a guide for determining a “safe” withdrawal rate. But the financial crisis of 2008-09 and its aftermath, including persistently low interest rates, has thrown the rule into question.
Many investors are asking, “Is the 4% Rule still valid?” What they should also be asking “Is the 4% Rule still valid for me?”
At its core, the 4% Rule says you can take 4% of your nest egg out in the first year, increase that withdrawal amount with inflation each year thereafter, and still not run out of money after 30 years even considering annual withdrawals and market gyrations.
Typically using a Balanced portfolio allocation (for example, 60% equities, 40% bonds), researchers have put the strategy through a litany of simulations of historical market performance, as well as various projections of future market scenarios to demonstrate the rule’s validity.
These simulations are often rooted in assumptions that the historical performance of asset classes relative to each other will be similar in the future. However, the recent financial crisis contributed to a breakdown in this relationship. Asset classes that traditionally moved inversely to each other instead all declined in value at once.
The 4% Rule (itself is only two decades old) is based on modern financial history going back to the 1920s, and takes into account the recessions, oil shocks, market bubbles, world wars and market cycles during that period. But do we have enough historical financial data and have we seen enough historical market patterns to have confidence in the models on which the 4% rule is based?
Some contend the financial crisis of 2008-09 and its aftermath changed the game: the potential for persistently low interest rates, lower portfolio returns than historical levels, and wider market gyrations impact the financial models and call for a lower safe withdrawal rate than 4%.
Find a Starting Point
Even if you think the 4% Rule has lost some luster it does not mean it has entirely lost its validity. It is a “rule of thumb,” never intended to be an immutable law etched in stone. But it can serve as an excellent starting point for determining a drawdown strategy.
And even if you agree with the critics, sticking with the 4% Rule doesn’t necessarily mean your nest egg won’t last 30 years; but it may mean that it does not provide for a “fail-safe” withdrawal rate for 30 years. It may mean that certain market scenarios could result in your nest egg running out of money sooner.
The more you believe those scenarios are likely – or the less comfortable you are taking that chance – the more you may want to ratchet down your initial withdrawal rate.
Alternatively, you can consider starting with the 4% Rule and pull back on withdrawals in the future if market performance negatively impacts your portfolio – but that can require some belt tightening and a lot of discipline that not all of us can muster.
And it is important to customize your withdrawal rate based on time horizon and portfolio allocation. For instance, a shorter time horizon than 30 years could enable you to increase your withdrawal rate.
Let's Clear the Air
There are a number of misperceptions over the 4% rule. Let's clarify a few key points:
What to Do? Build “Layers of Certainty”
Another way to feel more confident about making your nest egg last while increasing your withdrawal rate is to build a withdrawal strategy on top of a foundation of guaranteed lifetime income. In other words use some of your assets to increase the amount of income streams that are guaranteed to last for life, such as Social Security, pensions and annuities.
One strategy involves delaying Social Security as long as possible (to age 70) to maximize the annual income amount once the payments begin.
Annuities can also supplement Social Security and provide income that you can’t outlive. One variety that’s gaining attention of late is the deferred-income annuity (DIA), which locks in a guaranteed cash flow stream starting at some point in the future and lasts for the rest of your life and/or that of your spouse’s life (similar to Social Security).
One drawback of purchasing this type of an annuity is you lose liquidity and access to the funds you used to purchase the annuity. But since the annuity guarantees a lifetime cash-flow stream, even if the rest of your nest egg is spent down, you can have more confidence and flexibility to draw on your nest egg, and perhaps even enjoy your money more, during the years before the annuity kicks in.
The information presented is for informational and educational purposes only. Content presented is not an investment recommendation or advice and should not be relied upon in making the decision to buy or sell a security or pursue a particular investment strategy.
Do Not Sell or Share My Personal Information
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
*TD Ameritrade, Inc. and S&P Capital IQ are separate and unaffiliated companies and are not responsible for each other’s policies or services.
Annuities are long-term investments designed for retirement purposes. Withdrawals of taxable amounts are subject to income tax and, if taken prior to age 59½, a 10% federal tax penalty may apply. Early withdrawals may be subject to withdrawal charges. Optional riders are available at an additional cost. All guarantees are based on the claims paying ability of the insurer. An annuity is a tax-deferred investment. Holding an annuity in an IRA or other qualified account offers no additional tax benefit. Therefore, an annuity should be used to fund an IRA or qualified plan for annuity features other than tax deferral. Product features and availability vary by state. Restrictions and limitations may apply.
Investment and Insurance Products: Not FDIC Insured * No Bank Guarantee * May Lose Value
TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC, a subsidiary of The Charles Schwab Corporation. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2023 Charles Schwab & Co. Inc. All rights reserved.