The 4% rule

The introduction of the ARF brought a lot of benefits and flexibility to people in retirement. But with the retiree assuming all of the investment risk, it also brought a sense of vulnerability. What if I manage it wrong and run out of money? Retirement can be for 30 years plus and a lot can happen in that time. You start out with a big pot of money at the beginning of retirement and it is to do you until you get to the end...whenever that is.

The 4% rule

In 1994, William P. Bengen wrote Determining withdrawal rates using historical data in which he looked at how much people can withdraw from their portfolios in retirement and not run out of money. Using data going back to the 1920's, he concluded that the magic number was 4%. That 4% is of the initial amount adjusted each year for inflation. If you have a €1 million ARF, your first withdrawal is €40,000 and that amount is adjusted up and down each year based on the inflation rate at the time. He found in all situations, looking at all the really bad times from the 1920's, if you stuck to that rule, you would not run out of money in retirement.

Asset Allocation

But where was the money invested? Bengen's initial findings were based on 50% equities, 50% bonds and people would be able to maintain these withdrawals for at least 50 years. But who retires for that long? Most people were dead. So he ran different asset allocations with the minimum target of lasting a 30 year retirement.

In his different asset allocations, he found that the worst thing you could do is be too conservative and not have enough equity exposure. Those scenarios with less than 50% equities ran out the quickest. The superior returns of equities is essential to having a portfolio that will last the test of time.

In his research, he found that asset allocations of 50/50 to 75/25 offered very similar returns in terms of how long your portfolio latest in terms of time in all scenarios. Having more equities showed increased longevity on almost all of the scenarios. The greater returns of equities over bonds being evident here. However, in times of significant market crashes, the higher equity content sees much bigger crashes and an increased chance of seeing your portfolio nearly not achieving the goal you had set out with. Overall, Bengen recommends the 75/25 mix over the 50/50 mix.

Dangers

As already mentioned, having too little in equities and missing out on the growth that comes with equities is a big danger and is likely to result in your portfolio not achieving the desired outcome. That applies too if you started out with a 75/25 mix and reduced the equity content as fear took over in the midst of a market crash. When the markets recovered (as they always have), you do not get the benefit of this uplift because you are invested in bonds.

Inflation is as big a danger as market crashes. If the stock market falls and inflation stays low, your portfolio can cope. If there is a crash and inflation is high, it can have a big impact on your portfolio as the withdrawals are inflation adjusted. Of course, the prudent thing to do it reduce your withdrawals but people like having a certain lifestyle and may not want to go without, even if it means running out of money in the future.

Another issue is taking out too much when markets are doing well. If your first few years of retirement sees higher than expected growth with modest inflation rates, you may be tempted to take out more given that your fund has increased significantly while still taking out money. But when the next crash happens, the fund may struggle to maintain a higher withdrawal rate over the long term. Panic may take over and there is a rush to sell equities and buy into bonds, which we know is the wrong thing to do!

This paper has caused a lot of debate on whether it is actually correct and the rate has been revised up to 5% in all but the most disastrous of stock market crashes. Given Irish ARF holders tend to be cautious and take the minimum 4% of 5% of fund value and do not inflation link their withdrawal rate, using the inflation adjusted 4% rule would mean an increase in income for most.

Steven Barrett

13 May 2024