Does The ‘Four Percent Rule’ for Retirement Spending No Longer Apply?

Ally_blog_4percentrule3Since the 1990s, retirees have been told to follow the ‘Four Percent Rule’ when it’s time to withdraw from their retirement savings. This rule states that you can pull out 4 percent from your retirement savings annually – plus a bit extra to cover inflation each year – and live comfortably.

However, a recent story in The Wall Street Journal suggests the Four Percent Rule may no longer apply, mainly due to the current economic state and the risk of what the Journal calls a “prolonged market rout” during the first years of many people’s retirement. So simply withdrawing 4 percent may prematurely drain your savings.

The Four Percent Rule was initially the brainchild of California-based financial planner William Bengen and was based on retiree portfolios with 60 percent of their holdings in large-company stock and 40 percent in intermediate-term U.S. bonds. However, that allotment would fail retirees in some current scenarios.

For instance, the paper offers this example from investment firm T. Rowe Price Group: Someone who retired on January 1, 2000, with a portfolio of 55 percent stock and 45 percent bonds, and followed the 4 percent withdrawal rule (including inflation adjustments), would find their portfolio down by a third through 2010. T. Rowe Price calculates that this would leave the retiree with only a 29 percent chance of having enough savings to get through the next 30 years of his or her retirement.

So now that some believe the Four Percent Rule is becoming less relevant, what are your options? While you’ll probably want to talk with a financial planner to figure out what’s right for you, you may also want to consider these suggestions from the Journal:

1. Take Advantage of Safe Annuities

Wade Pfau of the American College of Financial Services tells the paper that a single-premium immediate annuity, paired with stocks, can be safer than bonds. He even goes as far to say, “There is no need for retirees to hold bonds,” and calls annuities “super bonds with no maturity dates.” The Journal does note, though, that annuities don’t work well if you’re in sudden need for cash. So depending on your situation, variable annuities may be work better for you.

2. Do Some Calculating

No matter where you’re stashing your retirement savings, the IRS life-expectancy tables in Appendix C of Publication 590 can help you get a more concrete idea of what your retirement will look like. The Journal suggests using your retirement savings balance as of last December 31 and dividing that balance by the life expectancy for your current age to figure out your annual withdrawal amount.

3. Let Stock Valuations Dictate Your Withdrawals

The Journal points to an approach crafted by Michael Kitces at Pinnacle Advisory Group, Inc., a wealth management firm headquartered in Columbia, Maryland, that can help you figure out safe withdrawal rates. Kitces uses the P/E 10, which measures current stock prices against the previous inflation-adjusted 10-year earnings of a company’s stock (the P/E stands for price-to-earnings). His rule says the higher the P/E 10, the less you should withdraw.

For instance, if the P/E 10 is above 20, Kitces says you can take out 4.5 percent during the first year of retirement, adjusting for inflation each year after. If it’s below 12 (or what the Journal refers to as “undervalued”) you could pull out 5.5 percent. You can monitor the P/E 10 in real time here 

What’s your strategy for spending your nest egg during retirement? How is your portfolio divided?

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