We’re living longer, so is the 4% rule a safe guide to retirement spending?

An annual report from financial services company Morningstar puts the spotlight on retirement savings and a safe withdrawal rate. It specifically looked at the ‘4 per cent rule’ and whether it was still sound in the face of increasing longevity.

Back in 2022, Annika Bradley, Morningstar’s director of manager research ratings-Australia, told YourLifeChoices that it was time to abandon this retirement spending rule of thumb.

She said the 4 per cent rule, which applies to a hypothetical portfolio with 50 per cent stocks and 50 per cent bonds, was convenient and fitted neatly into Australia’s financial planning infrastructure, but that it was too simple. “It doesn’t optimise for a retiree who may: live for a shorter or longer period than 30 years (longevity risk); wish to spend more in the early years of retirement; is unable to stomach market ups and downs, or holds significant levels of home equity.”

So what is the thinking in 2024?

The State of Retirement Income 2023, written by Christine Benz, John Rekenthaler and Amy Arnott, was released by Morningstar late last year. It had this to say about the 4 per cent rule. “My co-authors and I estimate that retirees drawing down income from an investment portfolio can now afford to withdraw as much as 4 per cent as an initial spending rate, assuming a 90 per cent probability of still having funds remaining after a 30-year time horizon.

“That figure is the highest safe withdrawal percentage since Morningstar began creating this research in 2021. (The highest starting safe withdrawal rate based on similar assumptions was 3.3 per cent in 2021 and 3.8 per cent in 2022.)”

So, does that mean all retirees can withdraw 4 per cent?

Your time horizon matters

Not necessarily, says Ms Benz. “Time horizon is super important when thinking about this. In our base case in this research, we assume a 30-year time horizon. So, we’re assuming, say, a 65-year-old who thinks that they will live until, say, age 95. And in that case, when we look at that 30-year time horizon, a 90 per cent probability of not running out of funds over that 30-year horizon, we come up with 4 per cent when we plug it all into our Monte Carlo simulations.

“But if you have, say, a shorter time horizon, maybe you’re a 75-year-old retiree and you’re thinking of more like a 20-year time horizon. In that case, you can take about 5.5 per cent according to our research. If you’re a young retiree, say, a 55-year-old with maybe more like a 40-year time horizon, you’d need to be more conservative. You’d need to take more like 3.3 per cent. So, think about your time horizon.”

She also says predictability of cash flows must be considered. “If you’re someone who wants a very steady pay cheque equivalent from your portfolio, which is kind of what we assumed in our base case, that generally points to needing to be more conservative in terms of your withdrawal, your starting withdrawal percentage. If you’re someone who is comfortable with more variability, you can arguably take more from your portfolio initially.”

Equity exposure

Withdrawal rate also depends on equity exposure.

Someone who is comfortable with more variability in terms of income stream would probably want to favour more growth assets, more equity assets, the study’s authors say. The highest safe withdrawal percentage corresponds to portfolios that have between 20 and 40 per cent equity exposure, they say. Someone who is comfortable with more variability in terms of the payday would probably want to favour more growth assets.

An added dimension to the research was data on how retirees actually spend.

Perhaps unsurprisingly, the finding was that people tend to spend less as the years go by, but surprisingly that trend was maintained across income bands.

Ms Benz says: “So, when we plug in the extent to which spending tends to actually trend down and we assume that natural downtrend in spending, we see a nice elevation in starting spending patterns.

“So, you can get the starting withdrawal rate over 5 per cent. You just have to be okay with that trade-off that further on in retirement, you have to spend less.

“But for a lot of people with tight plans who really want to maximise their retirement consumption, their enjoyment in those early years of retirement when they’re feeling good and they have pent-up demand to do fun things, they should take a look at that.”

What do others say?

The Motley Fool says that blindly following a formula without considering whether it’s right for your situation could lead you to either run out of money prematurely or be left with a surplus that you could have spent on the things you enjoy.

It summarises the pros and cons of rule as follows:

  • The rule is simple to follow.
  • You’ll have predictable income.

However, it says:

  • It isn’t dynamic enough to respond to lifestyle changes.
  • It doesn’t react to different market conditions.
  • It is somewhat outdated and can no longer guarantee that your funds won’t run short.

SuperGuide says the 4 per cent rule and Spend Your Age rule (when you draw down a percentage that is the first digit of your age) are handy tools in the absence of detailed information, but have limits.

“For starters, they are based on population averages and you’re not average. Some, like (William) Bengen’s 4 per cent rule, are based on overseas experience. Also, they are based on historic returns, so they won’t tell you with any certainty how the future will unfold.”

Of course, if the bulk of your retirement funds are in super, there are minimum drawdown rates based on your age. So the 4 per cent may need no further consideration.

Have you considered the 4 per cent rule as a guide to retirement spending? How confident are you about using it? Share your thoughts in the comments section below.

Also read: Is real estate the right asset to fund retirement?

Disclaimer: All content on YourLifeChoices website is of a general nature and has been prepared without taking into account your objectives, financial situation or needs. It has been prepared with due care but no guarantees are provided for the ongoing accuracy or relevance. Before making a decision based on this information, you should consider its appropriateness in regard to your own circumstances. You should seek professional advice from a financial planner, lawyer or tax agent in relation to any aspects that affect your financial and legal circumstances.

Janelle Ward
Janelle Wardhttp://www.yourlifechoices.com.au/author/janellewa
Energetic and skilled editor and writer with expert knowledge of retirement, retirement income, superannuation and retirement planning.
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