Will inflation put an end to the 4% rule? The 4% rule has been considered by many as an industry standard. The 4% Rule states that when you retire, you withdraw 4% your first year; each year, the amount is adjusted for inflation. However, people are now living longer, steep inflation and a bear market are calling into question if the four percent rule is still valid or if it should be re-adjusted to 2%.
There are valid concerns regarding the feasibility of the 4% rule, including such factors as rising stock prices and strong inflation. Let’s examine both.
Stock Valuations
Before the inflation rise of 2022, many had already buried the 4% Rule due to high market prices. Not very long ago, when the Shiller PE was above 35, prognosticators warned that the 4% Rule was dead.
In research published last year, Morningstar determined that the safe withdrawal rate going forward would be 3.3%. (NOTE: The study employed Monte Carlo simulations with specified inputs, but Bill Bengen’s 1994 work that introduced the 4% rule relied on historical data.)
Dr. Wade Pfau wrote a paper in 2010 wondering if individuals who retired in 2000 would see the poorest results since 1926. At the time, it seemed likely that they would. While inflation remained relatively modest, the S&P 500 remained flat for a decade. Inflation caused a $1 million portfolio invested in 75% equities and 25% bonds using the 4% rule in 2000 to decline to around $500,000 by 2010.
The subsequent bull market continued till 2021. The same retiree’s portfolio grew to over $600,000 by January 2022 after accounting for inflation and more than a decade of further withdrawals. If high inflation does not continue over the remainder of the decade, their chances are higher than in 2010, with little over seven years to go. The future will tell.
The connection between stock prices and the 4% rule has been understood for some time. Michael Kitces, a financial advisor, presented a report investigating the association between the two in 2008. He discovered a link of -0.74 between the Shiller PE and the safe withdrawal rate. In other words, the safe withdrawal rate decreases as the Shiller PE increases.
Now let’s discuss inflation. With the CPI reaching 8.2%, seniors wonder if the 1970s are being repeated., and it’s an essential question.
The worst moment to retire from the standpoint of a safe withdrawal was not during the worst market drop (1929 to 1931). It was in the late 1960s, thanks to inflation in the 1970s and early 1980s. To keep the same buying power, retirees must dramatically raise their annual withdrawals due to high inflation. Moreover, these greater withdrawals, once raised, influenced all future withdrawals (because deflation is uncommon).
The influence of inflation on the 4% rule has also been examined. Bill Bengen, the originator of the 4% rule, presented a study on this topic in 2020. Bengen added inflation to Kitces’ work on market values and the 4 percent rule.
The Shiller PE is a good, but not perfect, a predictor of the safe withdrawal rate for a particular year. Then he emphasized the significance of inflation, stating he could not stress enough the importance of inflation to the sustainability of a portfolio. The sequence of inflation that a retiree encounters after leaving the workforce is as crucial to the longevity of their portfolio as the sequence of investment returns, which has gotten considerably more attention. Inflation in the United States has typically been moderate for the past 100 years (excluding the 1970s and 1948-52).
Then, he coupled market values with inflation to forecast safe withdrawal rates. He discovered that a Shiller PE larger than 20 and inflation more than 5% (hey, 2022) would result in a safe withdrawal rate of… 4.5 percent.
Will History Be Repeated?
Kitces and Bengen’s work was based on historical data, and Morningstar’s work was predicated on Monte Carlo simulations. The distinction is important. Historical information is essential because what has occurred in the past might happen again. Simulations based on the Monte Carlo method are significant because history seldom repeats itself.
Still, inputs about predicted market returns, inflation, and the unpredictability of each are required for simulations. This necessitates assumptions, negative assumptions result in negative outcomes, and positive assumptions result in positive outcomes.
Future retirees should not abandon the 4% rule. They should use it as a cautious guide and not the golden standard. In unpredictable times (and all times are uncertain, even if they don’t appear to be), retirement spending flexibility and continuous income-generating opportunities are crucial.