Rate Debate

Richard Connor

THE 4% RULE HAS almost mythic status in the financial planning world. Originally suggested by Bill Bengen in a 1994 article, the rule provides a simple way for retirees to figure out how much they can withdraw from their portfolio without running out of money. In a recent article, Bengen updated his rule.

The rule defines the maximum amount retirees should withdraw from their portfolio in the first year of retirement. Got a $500,000 nest egg? The 4% rule suggests you can pull out $20,000 in the first 12 months after you quit the workforce. Included in this sum are any dividends and interest you receive.

In subsequent years, you would withdraw the same amount, but adjusted upward for inflation. In all of the historical scenarios that Bengen analyzed, this strategy successfully ensured that a retiree’s savings lasted at least 30 years. Bengen assumed a portfolio of 50% S&P 500 and 50% Treasury bonds. To come up with his rule, he looked at 76 years of historical stock and bond returns

In a 2006 book, Bengen updated his rule to 4.5%. He accomplished this by adding U.S. small-company stocks to the portfolio. His research showed that 4.5% rate worked for all rolling three-decade periods since 1926. He used similar assumptions—”a tax-advantaged account, annual [inflation] adjustments and a minimum of 30 years of portfolio longevity.” The 4.5% turned out to be the maximum that worked for an individual who retired and faced a “worst case” scenario of terrible market returns and high inflation. Bengen’s research also showed that individuals who retired during more favorable periods were able to successfully withdraw up to 13%.

Michael Kitces expanded on Bengen’s original analysis in a 2008 article. Kitces considered an additional parameter, the market’s current valuation as measured by the cyclically adjusted price-earnings (CAPE) ratio, otherwise known as the Shiller P/E or P/E 10. CAPE takes the S&P 500’s current value and divides it by average inflation-adjusted earnings for the past 10 years. Kitces’s analysis showed an inverse relationship between CAPE and the maximum safe withdrawal rate. In other words, the higher CAPE is when you retire, the lower the safe withdrawal rate.

This approach makes intuitive sense. If you retire at a time of historically high valuations, you have a smaller chance of receiving average market returns in future. Kitces’s research also provided insights into the importance of the first 15 years of portfolio returns, as well as whether a retiree should revise his or her investment mix based on the market’s CAPE multiple at retirement.

In Bengen’s recent article, he updated and expanded his original research by using quarterly historical returns. That increases the number of data points significantly. As before, he determines historically safe withdrawals rates for a 30-year retirement period, assuming a tax-advantaged portfolio. The portfolio analyzed included a mix of 30% U.S. large-company stocks, 20% U.S. small-cap stocks and 50% intermediate-term U.S. government bonds.

In this new analysis, Bengen improves on Kitces’s work by adding another variable to the mix—the starting inflation rate. He organized the results in groupings according to both the 12-month inflation rate and the stock market’s CAPE ratio at the time of retirement. Lower inflation environments and low CAPE values lead to higher safe withdrawal rates. As of this writing, trailing 12-month inflation is 1.2% and the current CAPE ratio is over 30. According to Bengen’s article, that suggests the maximum safe withdrawal rate is 5% for today’s newly minted retirees.

A caveat: There’s currently debate about whether the stock market is as overpriced as it appears, because recent corporate earnings have been crushed by the COVID-19 economic slowdown. On top of that, some argue that the dominance of technology companies in the S&P 500 has skewed market valuations higher. Tech companies’ reported earnings are depressed by their hefty spending on research and development, and the way that spending is treated under current accounting standards.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. Rick enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. His previous articles include For Goodness SakeThat Monthly Check and Margin of Safety. Follow Rick on Twitter @RConnor609.

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