What percentage of an investment portfolio can retirees withdraw without outliving their money? We look at Bengen’s 4% rule and its relevance for global equity investors.
Investing may not be rocket science, but it's worth noting that one of its most renowned principles stems from a former student of aeronautics and astronautics, who went on to become a financial adviser. Thirty years after its inception, William Bengen's "4% rule" still holds weight in the financial world.
Bengen’s rule suggests that retirees can safely withdraw approximately 4% of their overall retirement investments in the first year of retirement, adjusting subsequent withdrawals to account for the rising cost of living (inflation).
According to Bengen’s calculations, this approach can sustain most portfolios for over 30 years, helping retirees to reduce the likelihood of running out of funds in their latter years.
To grasp the dynamics at play here, it is important to understand what the rule truly signifies, and why it has often been misinterpreted and improperly implemented.
From conception to criticism
Upon graduating from Massachusetts Institute of Technology, Bengen joined his family-owned soft drink bottling company. However, it wasn't until he left 17 years later to become a financial adviser, that he and his peers conceived the 4% rule. This rule was based on analysis of 75 years' worth of investment returns and retirement scenarios, using a model portfolio with 50% allocated to large-cap stocks and 50% five-year bonds.
In his landmark 1994 paper, Determining Withdrawal Rates Using Historical Data, Bengen described a 5% withdrawal rate as “risky” and anything above 6% as “gambling”. He advocated for an initial withdrawal rate of 4.2% in the first year of retirement, followed by adjustments for inflation each subsequent year.
However, the critical component of adjusting withdrawals is sometimes overlooked, potentially jeopardising retirees’ financial security. Recent years have highlighted the rule’s limitations, particularly in times of high inflation and low interest rates, when blindly sticking to 4% could result in retirees outliving their money.
In the current decade (2020s), such an approach would likely have proven sub-optimal, particularly considering the inflation and interest rate surges following COVID-19. What you could buy with the initial 4% withdrawal may have proved disappointing.
Equally, sticking with the initial level of withdrawal is unlikely to be prudent when inflation and interest rates are low. This is why so much criticism of the 4% rule emerged during the “easy money” era when interest rates were minimal. Studies during this period found the ability of portfolios to fund retirement could reduce dramatically in the face of historically low bond yields. One piece of research¹, published in 2013, unequivocally declared: “The 4% rule is not safe in a low-yield world.”
Normality, dividends, and diversification
But here is the crux: it is the “easy money” era, not the periods before or after it, that stood out as an anomaly. The triumph of growth-oriented equity investments from the aftermath of the global financial crisis until the onset of the pandemic led many investors to overlook the significant role shareholder dividend payments can play in portfolios.
In the 2010s, for instance, dividends contributed just 17% to the annualised total return² of the S&P 500 Index (which tracks the 500 largest listed companies in the U.S.). Yet in the 1980s, when interest rates and inflation were more volatile, the contribution from dividend payments to the performance of S&P 500 performance was 28% – and in the 1970s, when they were running riot, it was 73%³.
Today’s evolving landscape could aptly be termed as a return to the “old normal”. Once again, the economic environment is currently prompting businesses to demonstrate discipline – prioritising realistic dividends, prudent budgeting and good governance. Considering this shift, Bengen’s principle, when properly implemented appears more relevant than it has for many years.
In tandem, the importance of holding a diversified portfolio of equities and bonds is increasingly apparent, consistently emphasised as crucial to the 4% rule’s effectiveness4. It matters today because of another product of the “easy money” era: the cult of the investment theme.
While certain investment themes like technology hold allure, investors are realising the wisdom of broadening their investment horizon in an unpredictable age. For more on this, read Stephen Anness’s article “Thinking outside the Magnificent Seven.”
If we take the example of a global equity income portfolio, it is not rocket science to see how it might have appeal to investors seeking both dividends and diversification.
Bengen’s rule will always attract controversy, if only because circ*mstances almost invariably change. Though conceived 30 years ago, its relevance to retirement planning continues5.
