What Is the ‘4% Rule’ for Retirement Income?

If you have looked into the level of income you can reasonably draw from your retirement savings – known in investment circles as your drawdown rate – you may have encountered the “4% rule”.

Basically, this rule says that if you withdraw 4% of your capital in the first year of your retirement and increase the rand amount by the inflation rate each year after that, your savings will last you at least 30 years. If your initial drawdown is higher than that, there is a chance that your money will run out before 30 years are up.

Say you have savings of R10 million and the inflation rate is 5%. According to the rule, you can safely withdraw 4%, or R400 000, in the first year; R420 000 (R400 000 + 5%) in the second year; R441 000 (R420 000 + 5%) in the third year and so on, ignoring what happens in the markets.

This rule, postulated in 1994 by American financial planner William Bengen after applying different drawdown rates to historical US equity and bond returns, has become widely accepted as a guideline in retirement planning. However, the rule has also generated vigorous debate, with some investment experts arguing that 4% is too low and others saying it is too high.

Bengen’s paper, “Determining withdrawal rates using historical data”, appeared in the Journal of Financial Planning in October 1994. The opening paragraphs discuss the problem of using average returns to formulate a drawdown strategy. Bengen writes: “It pays to look not just at averages, but at what actually has happened, year by year, to investment returns and inflation in the past … The long-term effects of certain financial catastrophes, such as the [Great] Depression or the 1973-1974 recession, can overwhelm the averages.”

He then calculated how long an investment portfolio (comprising 50% bonds and 50% equities) would last, starting each year from 1926 to 1976, under four withdrawal scenarios: using a 3%, 4%, 5% or 6% initial drawdown. The period included three great market declines: 1929-1931 (the early years of the Great Depression, when US stocks dropped by 61%); 1937-1941 (stocks dropped by 33%); and 1973-1974 (stocks dropped by 37%). Interestingly, bonds performed well during those three episodes, offsetting to a certain extent the equity losses.

Bengen based his calculations on the following assumptions:

• The withdrawals are made annually in arrears – in other words, at the end of each year. (Bengen did this for ease of calculation.)

• The absolute cash value is increased (or decreased) by the Consumer Price Index inflation rate each year.

• Investment fees are not taken into account.

• The 50-50 equity-bond allocation must be maintained, which may require the occasional rebalancing of the portfolio.

Four drawdown scenarios

• 3% drawdown: Bengen found that, under the 3% drawdown scenario, the 50-50 portfolio sustained itself for at least 50 years (the limit Bengen set himself), whichever year one started.

• 4% drawdown: Withdrawing 4% of capital, the portfolio lasted for at least 50 years in about 80% of cases. In 10 starting years, the portfolio ran out before 50 years and in five of those years it ran out before 40 years. The worst two starting years were 1965 and 1966, when the portfolio ran out soon after the 30-year mark.

• 5% drawdown: In this scenario, portfolios in 32 (about 60%) out of 51 starting years ran out within 50 years. Of these, 15 ran out between 30 and 50 years and 17 ran out between 20 and 30 years. The worst starting year was 1966, when the portfolio barely made it to 20 years.

• 6% drawdown: With a 6% initial drawdown, 14 of the 51 portfolios ran out within 20 years, the worst being those starting in 1968, 1969 and 1973, after which they lasted only about 17 years.

Conclusions

You may ask how Bengen could be sure of the longevity of the portfolios of the late ‘60s and ‘70s when he published the paper in 1994. It appears that returns from equities were so positive in the ‘80s (apart from a dip in 1987), that he could make his longevity predictions with confidence.

Bengen also experimented with different asset allocations, changing the ratio of equities to bonds. He found that the 50-50 allocation gave the best longevity under all drawdown scenarios, concluding that the equity allocation could be higher but not lower than 50%.

“Stock allocations lower than 50% are counterproductive, in that they lower the amount of accumulated wealth as well as lowering the minimum portfolio longevity. Somewhere between 50% and 75% stocks will be a client’s ‘comfort zone’,” he wrote.

The main conclusion was that an initial drawdown of anything over 4% is risky for retirees needing an income for 30 years.

A follow-up-article, “Is the 4% rule useful for South African retirees?” , examines whether the 4% rule is relevant as a guide for South African retirees today, three decades after its emergence.