A commonly accepted retirement ‘rule’ is that you should withdraw no more than 4% of the total value of your living annuity during your first year of retirement if it is to be sustainable. But in a world rocked by a pandemic that has resulted in prolonged disruption to global markets and heightened financial insecurity, is this rule still valid to pensioners today?
The origins of the 4% ‘rule of thumb’
In 1994, US financial planner Bill Bengen published the results to his new retirement distribution strategy research, which showed that by drawing down 4% from a balanced investment portfolio, you would not run out of money over a 30-year period.
Another research paper, The Trinity Study completed in 1998, looked at drawdowns from various portfolio allocations from a 100% equity holdings portfolio to a balanced portfolio, over varying timeframes up to a 30-year planning horizon. It similarly revealed that over the same 30-year period, a 4% drawdown rate from either a 100% equity portfolio or a balanced portfolio yielded a 95% success rate – in other words, a 5% chance of running out of money.
Relevance of the research for today’s retirees
A lot has changed since both sets of research were conducted over two decades ago. Life expectancy has risen by more than six years since the start of the millennium, meaning we should be planning for a retirement period beyond 30 years.
Yet, at Just SA we believe that there is still value to be gained from the findings.
The primary takeaway is that if your retirement investment portfolio needs to sustain your lifestyle for a longer time, you need a lower withdrawal rate. You will increase your success rate by reducing your withdrawal rate.
Rising inflation makes it challenging to sustain your spending, as your real withdrawal rate will increase every year as your expenses increase.
In terms of asset allocation, while bonds may help to increase the certainty of success for low to average withdrawal rates, they may significantly reduce the returns of your portfolio. However, including an allocation to bonds will likely decrease the volatility of your portfolio and could also help mitigate sequencing risk i.e. the danger that the timing of your withdrawals will harm your overall rate of return.
A significant allocation to equities in your portfolio could afford a higher withdrawal rate. But asset allocation preferences have also evolved over the years, with many investors opting for balanced portfolios over 100% equity or high equity.
Perhaps most importantly, the research findings suggest that even with a 4% drawdown, you are not guaranteed to not run out of money in retirement.
And while The Trinity Study’s 5% failure rate might be outdated, and largely depends on how you structure your investment portfolio, would you get in an aeroplane that has a 95% chance of arriving at its destination?
What precautions can retirees take?
As all investors should know, past performance is not an accurate measure of future performance, and therefore pensioners cannot rely on investment performance alone to provide their bread and butter in retirement. And as the 4% rule is outdated, it is more beneficial to view it as a guiding principle in a bigger conversation around retirement planning that suits your unique circumstances, where you ensure that you are taking reasonable measures to de-risk yourself.
One approach is to look for alternatives that allow you to have a higher drawdown rate or increase your consumption of your retirement capital, without having to rely on investment performance, to cover your basic expenses.
The only way to increase your drawdown rate without increasing your risk of running out of money is with a guaranteed life annuity. This is because life annuity rates are usually higher than the recommended safe withdrawal rates and income is guaranteed for life.
 A 50/50 mix of large cap U.S. stocks and government bonds, adjusted each year to inflation
 The estimates confirm the trend for longevity: lifespans are getting longer, World Health Organisation (2019)