The 4% retirement rule can be supercharged

In the early 1990s, in response to client questions, William “Bill” Bengen initiated research on the sustainability of withdrawals from stock and bond portfolios. He first published his research in 1994, concluding that an initial safe withdrawal rate was 4.15%, but publications truncated it to 4%. The industry quickly nicknamed this the “4% Rule.” Bengen later called it the “safemax,” or maximum safe withdrawal, rate.

For those unfamiliar with this rule, it suggests that traditional retirees (around age 65) can safely withdraw 4% of their retirement portfolio in the first year and adjust that number for inflation in subsequent years and not run out of money over a 30-year period.

To arrive at the 4% rate, Bengen studied historical market returns covering 50-year periods beginning in 1926 and ending in 1992. He tested five possible asset allocation models, ranging from 0% to 100% stocks, with the greatest attention paid to the 50% and 75% stock portfolios. He settled on a diversified portfolio split of 50% large-cap U.S. stocks and 50% intermediate-term U.S. government bonds. He tested eight distribution rates ranging from 1% to 8%, with the most attention paid to 3%, 4%, 5% and 6%. The research showed that even during the worst 30-year economic scenarios, a 4.15% initial withdrawal rate would not have depleted the portfolio.

As his research has continued over the past 30-plus years, he has included more data, which changed the safemax number. In 1997, he introduced small-cap stock to increase portfolio diversification and increased the safemax number to 4.3%. In 2006, it increased to 4.5% to account for distributions from tax-advantaged retirement accounts.

In his book “A Richer Retirement: Supercharging the 4% Rule to Spend More and Enjoy More,” Bengen announced a “universal safemax” rate of 4.7% for retirees. This reflects using a more diversified portfolio (55% stocks, 40% bonds, 5% cash) and incorporating decades of new market data. Last month, he suggested that a starting rate of 5.25% to 5.5% would likely be safe for today’s retirees due to more moderate inflation.

His “4% Rule” has always been a guideline or starting point. I saw him present his research in 2006. He used an analogy of “assembling a layer cake.” You start with the number derived from the above assumptions. Each time you modify those assumptions to meet your personal situation, you add another layer that impacts your personal safemax number. His new book highlights the eight elements that go into finding your personal safemax number:

◗ Personal retirement withdrawal plan: He uses a cost-of-living adjustment that works like Social Security.

◗ Asset allocation: The targeted rate of return on your portfolio will drive the withdrawal rate. His book guides you to build a highly diversified portfolio of high-quality assets using mutual funds and exchange-traded funds.

◗ Taxable versus non-taxable portfolios: The tax aspect of different types of accounts will change the final number.

◗ Portfolio rebalancing: He recommends bringing your portfolios back to their original percentage once a year.

◗ Striving for above-market returns: Taking additional risk in your portfolio can prove costly. If you make a mistake and don’t get the returns you hope for, you have a higher risk of running out of money or making drastic spending cuts.

◗ Withdrawal timing: Your safemax number is adjusted lower if you want to receive periodic distributions. His assumption was that there was one lump-sum distribution at year end.

◗ Leaving a legacy: If you want a certain amount of money to be left in your account, that will lower the initial withdrawal rate.

◗ Planning horizon: Bengen’s formula plans for a 30-year horizon. Adjusting that time will impact your safemax number.

I tell my clients that if I knew when they were going to die, spending decisions would be easy. Instead, it is an ongoing balancing act between current retirement spending and making money last a lifetime. It varies based on your individual preferences, life experiences and tolerance for risk. It can and should be adjusted periodically.•