The 4% spending rule no longer works thanks to inflation

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Bill Bengen first devised the 4% retirement rule in 1994. Since then, retirees have relied on this rule to help them determine how much they should spend in retirement. The rule is relatively simple. You add up all your investments and withdraw 4% of that total in your first year of retirement. In subsequent years, you adjust the amount you withdraw to account for inflation.-

So if you have $1 million saved for retirement, you’ll spend $40,000 the first year, and if inflation is 2% the next year, you’ll withdraw $40,800 that year. The 4% rule assumes that when you retire your portfolio is 50% stocks and 50% bonds.

Based on Bengen’s original paper, this approach would have protected retirees from running out of money for every 30-year period since 1926, even taking into account the Great Depression, the tech bubble, and the financial crisis. of 2008. However, due to the combination of high inflation and high stock and bond market valuations, Bengen thinks retirees will need to make some adjustments to their spending.

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Reduce expenses now

Bengen, who retired in 2013, suggests that given today’s unprecedented economic situation, retirees will need to cut spending and reduce their withdrawal rate. A recent study by Morningstar shows that the 4% withdrawal rate was too aggressive. His research recommends a starting withdrawal rate of 3.3%.

This assumes a 50/50 portfolio of stocks and bonds and a 90% certainty of not running out of funds over a 30-year period. The key thing he discovered is that the more flexible retirees are with their spending, the more likely they are to increase the rate of withdrawal over time.

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Impact of high inflation and high stock market valuations

The average US inflation rate since 1913 has been 3.1%. With inflation now at 8.3%, withdrawals under the 4% rule are increasing significantly. This means that the portfolio will have to generate higher returns or there is a higher chance that the portfolio will be depleted.

Another issue raised by Bengen is that stock market valuations are at historically high levels. Shares are now trading at around 36 times corporate earnings over the past decade. Bengen says, “That’s double the historical average. While low interest rates provide some justification for higher stock valuations, I think the market is expensive.

When stock market valuations are high, a bear market normally follows to bring prices back to their mean. So there is a good chance that there will be a recession or a bear market in the near future, if we are not already experiencing one. During these times, retirees will need to be extra careful when making withdrawals to ensure they don’t run out of money.

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After cutting spending, Bengen recommends retirees reduce their exposure to stocks and bonds. This would reduce their risk in the event of a recession or a bear market. By having more cash or other assets such as income-producing real estate, when the market goes down, it may be possible to buy stocks when they are cheaper. However, retirees should be careful. The important thing is not to try to time the market, as this can lead to even bigger problems.

Given current economic conditions, retirees will need to rethink the popular 4% rule. Experts, including the creator of this popular retirement income strategy, believe it’s outdated and that retirees should assess their financial plans and spending to manage the risk of running out of money. The key is to be flexible with your finances and keep a long-term financial view.

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