Pittsburgh – — Conventional wisdom for two decades or so in the financial services industry has been that retirees stood a good chance of making their savings last a lifetime as long as they were disciplined enough to withdraw only about 4 percent of their nest egg each year for living expenses.
At the time the “4 percent rule” was formulated in the 1990s, the Federal Funds interest rate floated between 8.1 percent and 6.24 percent.
Today’s interest rates have been stalled near zero percent for so long that many financial advisers have come to believe the 4 percent rule is out of touch with the reality retirees now face.
“If you go back to when rates were higher on money market accounts and fixed bonds, you could invest conservatively and earn close to that 4 percent distribution. However, today, if you invested conservatively in money markets and bonds, you would earn about 1 percent,” said Nick Besh, investment director at PNC Wealth Management in Pittsburgh.
“So, to meet your retirement needs you would have to invest more aggressively, most likely in stocks,” Besh said. “The other side of that is stocks have a lot more risk as we are seeing now. Stocks have had the worst start to a year in history.”
Several factors come into play when deciding a safe rate of withdrawals, Besh said.
The size of your retirement portfolio, your life expectancy, market return expectations, timing of the distributions and risk tolerance must all be considered. Other sources of income also become part of the equation.
Morningstar Investment Management in Chicago found in a 2013 study that if bond rates remained at these low levels, retirees stood a 50 percent chance of running out of money in 20 years if they stuck to the 4 percent withdrawal rule. That’s assuming they had a portfolio of 60 percent bonds and 40 percent stocks.
Morningstar found if retirees started with an initial withdrawal rate of around 2.5 percent, it would raise the odds of making the money last.
Bernard Carter, an investment strategist at Hapanowicz & Associates in Pittsburgh, said the current low interest rates are a good example of why it’s best when constructing rules of thumb to focus on long-term market performance.
“The most important thing for us is to look at each client individually,” Carter said. “The benchmark for expected rate of return on the portfolio, for risk tolerance and an appropriate withdrawal rate from the portfolio is the client himself. It’s really a client-by-client, case-by-case customized determination.”
The 4 percent withdrawal rule was created in 1994 by financial planner Bill Bengen in response to several anxious clients asking him the same question: How much could they spend in retirement without running out of money?
Bengen, who graduated from the Massachusetts Institute of Technology with a bachelor’s in aeronautics and astronautics, turned to his computer. He found that retirees who withdrew no more than 4 percent of their initial portfolio, adjusted for inflation, on an annual basis during retirement years could create a paycheck that lasts for 30 years.
Critics of the rule say it was based on economic conditions in the U.S. during a specific time in history.
“When this premise was formulated, not only were rates higher, but we were also embarking on a bull market for bonds. We might be on the threshold of a bear market for bonds,” said Adam Yofan, president of Alpern Wealth Management in Pittsburgh.
“To some extent, the 4 percent rule is fallacy because everyone has different spending requirement and pots of money,” Yofan said.