Rethinking the 4% rule: Modern approaches to retirement withdrawals

Many Americans' retirement plans are built on rule-of-thumb guidelines for withdrawal amounts and predicted returns. However, experts warn that delving into the minutiae can pay off.

While these general guidelines provide a starting point, it's crucial to understand that individual circumstances can significantly impact retirement planning. Factors such as health conditions, lifestyle choices, and unexpected life events can all play a role in determining the most appropriate withdrawal strategy. Additionally, the changing economic landscape and evolving market conditions necessitate a more dynamic approach to retirement planning, one that can adapt to new realities as they emerge.

One example is the 4% rule, which states that if someone withdraws 4% of their nest egg in their first year of retirement and adjusts it annually for inflation, they will have enough money to last 30 years.

UBS conducted a summer study on its clients' 60/40 portfolios, an investing style that allocates 60% to stocks and 40% to fixed-income assets and has lately regained popularity after being criticized in 2022. The bank estimates that annualized future returns for such portfolios will be 5.9%, three percentage points lower than the previous 30 years.

It's important to note that while the 60/40 portfolio has been a staple of retirement planning for decades, recent market volatility and low interest rates have led some financial experts to question its efficacy. Alternative strategies, such as incorporating a higher percentage of dividend-paying stocks or exploring real estate investment trusts (REITs), are gaining traction among forward-thinking investors. These approaches aim to provide a more stable income stream in retirement while potentially offering better protection against inflation.

Assuming such returns and a 2.4% inflation rate, UBS estimates that retirees would need to withdraw between 4.1% (for a more conservative portfolio) and 4.5% (for a more aggressive one) to cover a 30-year retirement with an 85% likelihood of having enough money.

"Stock market valuations, interest rates, and earnings growth expectations are less attractive, while we expect market volatility to be about the same as it was historically," according to the study authors. "This means that we need to take historical analyses—like those used to originally come up with the so-called '4% rule'—with a grain of salt."

The Rule Has a Place—If Used Carefully.

Experts agree the 4% guideline is useful if retirees don't rely too heavily on it. David Flores Wilson, a managing Partner at Sincerus Advisory, says it is useful when combined with other variables.

"There's no substitute for doing the math, and that means trying to understand what people's spending levels are, what their expected income sources and assets will be in retirement, and then running projections [that include] assumptions about inflation and market returns," he added.

Financial literacy plays a crucial role in successful retirement planning. As retirement landscapes become increasingly complex, there's a growing need for individuals to educate themselves on financial matters. Many financial institutions and community organizations now offer free or low-cost workshops and online courses to help people better understand retirement planning concepts. By investing time in financial education, retirees can make more informed decisions about their withdrawal strategies and overall financial health.

According to the Bureau of Labor Statistics, the average yearly expenses for people aged 65 to 74 in 2022 were $60,844. Using the 4% rule, someone intending to spend $60,000 per year in retirement would need approximately $1.5 million, but someone spending $40,000 per year would require approximately $1 million. (These basic estimates are illustrative and do not account for inflation.)

However, a larger withdrawal rate does not necessarily imply that you should save more. That value does not account for any differences in a portfolio's performance over a given time period.

Scott Sturgeon, CFP and founder of Oread Wealth Investors, stated that while investors with more aggressive portfolios may see larger gains, they are also more likely to experience drawdowns, increasing their risk of running out of money in retirement.

The concept of sequence of returns risk is particularly relevant when discussing withdrawal rates in retirement. This risk refers to the potential negative impact of experiencing poor investment returns in the early years of retirement when withdrawals are being made. A string of bad years at the beginning of retirement can significantly deplete a portfolio, making it difficult to recover even if better returns follow. This underscores the importance of having a flexible withdrawal strategy and potentially maintaining a cash buffer to weather market downturns without having to sell investments at inopportune times.

And Jason Siperstein, President and Wealth Advisor at Eliot Rose, stated that many of his clients do not follow fixed withdrawal rates in retirement: They are frequently greater early on, up to 8%, before falling to as low as 2% after Social Security payments begin.

"There's more nuance to doing this than simply looking at the initial portfolio value and assuming you can withdraw 4% of that amount each year in perpetuity," according to Sturgeon.