New study on ‘4% rule’ suggests different approaches to retirement strategies

A study co-authored by a faculty member in Western Carolina University’s College of Business and colleagues at two other universities indicates that recent changes in economic market conditions may necessitate a closer look at a long-held retirement strategy.

In the study, Ya Anna Dai, WCU assistant professor of finance, and her co-authors examined the popular “4% rule,” a retirement withdrawal strategy that presumes retirees can safely withdraw 4% of their savings during their first year of retirement, with future withdrawals adjusted for inflation each ensuing year for a 30-year period.

Their findings signal that retirees and financial advisers should consider the adoption of new approaches to the expenditure of retirement savings that are better suited for today’s volatile economy and strategies that are more personalized than the traditional “4% rule.”

The study is the basis for a paper titled “The Death of the 4% Rule: New Market Conditions and Retiree Needs Require Rethinking Retirement Spending” by Dai; Karyl B. Leggio, professor of finance in the Sellinger School of Business and Management at Loyola University Maryland; and Donald Lien, who holds the Richard S. Liu Distinguished Chair in Business at the University of Texas at San Antonio. Their paper has been accepted for publication in The Journal of Retirement.

“Our research suggests that the ‘4% rule’ might not be the best withdrawal strategy. Instead of withdrawing a fixed percentage (adjusted for inflation) from the initial retirement fund, it may be more prudent for retirees to align annual withdrawals with the remaining portfolio value, adapting to market fluctuations,” Dai said.

“In striving for a delicate balance between ensuring long-term financial security and avoiding premature fund depletion, we propose two more-effective strategies: following age-based withdrawal percentages outlined in the Internal Revenue Service’s Required Minimum Distribution (RMD) tables or opting for a fixed 6% rate, adjusted for inflation, both linked to the remaining portfolio value,” she said.

Their research suggested that it would be advisable for retirees to take a personalized approach to withdrawals, factoring in both the portfolio value and individual needs, while steering clear of rigidly sticking to a 4% withdrawal rate based on the initial retirement wealth.

“Choosing the original concept of withdrawing 4% of the initial wealth at retirement increases the risk of outliving funds,” Dai said. “Conversely, withdrawing 4% or even a higher rate, like 6%, of the remaining portfolio value can help sustain funds throughout the retiree's lifetime. However, it’s crucial to acknowledge that this approach introduces variability in annual withdrawal amounts, adding complexity to the planning process.”

In many cases, it may make more sense for retirees and their financial advisers to embrace a withdrawal plan tied to Required Minimum Distributions, which is an age-based strategy, she said. “This is particularly relevant when retirees depend on interest income and dividends, as there’s a tradeoff between ensuring long-term financial well-being during retirement years and avoiding premature fund depletion,” Dai said. “Additionally, initiating savings early and increasing contributions for retirement can play a vital role in preventing early fund depletion and contribute to long-term financial security.”

Several recent changes in economic conditions combined with common risk factors have had a negative impact on the use of the 4% rule for retirement planning – a rule that never should be considered hard-and-fast even during the best of times because of varying individual circumstances, Dai said.

“It’s crucial to recognize that retirement expenses fluctuate, and predicting lifespans remains uncertain. Before embracing any fixed spending rule, including the 4% rule, it’s essential to consider several key risks,” she said. These include:

Sequence of returns risk: “If early retirement years witness more market downturns than upswings, your retirement savings may not endure as long as they would if negative market trends occurred later in retirement,” Dai said.

Longevity risk: “While the average lifespan has increased since the inception of the 4% rule prior to COVID-19, it’s important to note that not everyone falls within the average. As of 2020, the U.S. Census reported more than 60,000 women and nearly 15,000 men of age 100 or older,” she said.

Market risk: “Past performance doesn’t guarantee future results. Unprecedented events, such as prolonged periods of inflation or market crashes, may occur, and the 4% rule may not adequately account for such fluctuations. Market conditions today differ significantly from those of the 1980s,” she said.

For the study, Dai and her co-authors examined the risk factors and assessed the efficacy of retirement fund withdrawal strategies using what are commonly called “Monte Carlo simulations,” which are models used to predict the probability of a variety of outcomes when the potential for random variables is present. Monte Carlo simulations, which help explain the impact of risk and uncertainty in prediction and forecasting models, are among the most frequently used processes for making statistical interpretations.

Dai and her co-authors believe that their research also shows the need for additional study on retirement withdrawal strategies beyond the 4% rule.

“In our current study, we operate under the assumption that retirement funds are invested in large stocks and bonds. There could be value in investigating the inclusion of small stocks in the investment portfolio. Additionally, there is potential for future research to delve into dynamic withdrawal strategies that consider a lifetime spending curve. Such strategies might involve higher expenses during the initial years of retirement and increased spending in later years, driven by factors such as elevated medical expenses,” she said.

“Furthermore, while our paper assumes withdrawals at the beginning of each year, there is room for future research to compare the effectiveness of monthly withdrawals. This could shed light on potential variations in outcomes based on different withdrawal frequencies,” Dai said.