The 4% Rule Just Became the 2% Rule

John D. Perrings

In a recent article interviewing Wade Pfau, professor of retirement income and co-director of The New York Life Center for Retirement Income at The American College of Financial Services, talks about the drastic effects of the COVID-19 situation on retirement distributions.

In the financial planning world, there is a rule of thumb that says, in retirement, you can withdraw 4% of your retirement assets every year and have a low probability of running completely out of money before you die. This is known as the “4% Rule” or sometimes referred to as a Monte Carlo simulation.

The biggest danger to a retirement plan is the performance of retirement/savings assets in the early years of retirement. Negative returns in the early years of retirement can have devastating effects on retirement accounts. This is known as Sequence of Returns Risk (see video) and COVID-19 is creating some serious concern for recent retirees.

“Buffer Assets” to the rescue. Read on…

From the interview:

INTERVIEWER: When it comes to income planning, does the 4% rule of thumb in retirement still apply?

WADE PFAU: No. The probability that it would work is a lot lower now. It worked in the U.S. historically, but [previous years] never dealt with low interest rates and high stock market valuations at the same time.

What’s the so-called rule now?

I did some updates in mid-March; and for an investor taking a moderate amount of risk, I put out 2.4% as my equivalent of the 4% rule. That’s still about the same today.

It’s roughly half the amount of the traditional rule and means that a typical retiree would need to pull back spending significantly. Ordinarily, they’d have the option to delay retirement by working longer. What about now?

Working longer is the best way to get a retirement plan back on track, but the tragedy of the pandemic is that a lot of people may lose that lever, depending on which sector of the economy their job is in and other factors. However, those who do have the flexibility to continue working might look into it as a way to delay retirement.

You’ve said that during the first 10 years of retirement, market performance drives outcomes. But the market is in terrible shape. Is there a lesson to be learned here?

Yes. The pandemic and resulting market decline make it hard for people who are thinking of retiring this year. This speaks to [trying] not to fall into that trap: It’s a reminder that you can’t necessarily rely on a high rate of return from your investment portfolio as the key way to fund your retirement.

[…]

Any other options for those who planned to retire this year?

There are two “buffer assets” you can spend from temporarily: reverse mortgages and cash value on whole life insurance policies.

Tell us about the insurance-policy option.

Someone with whole life insurance can borrow against its cash value to cover spending on a temporary basis so they don’t have to sell their portfolio of assets at a loss. It’s a loan that can help bridge the gap in spending so they’re not having to take that [money] from their portfolio.

[…]

Read the full article on ThinkAdvisor here ->

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About the Author

My mission is to teach people how to strategically accumulate capital in a way that makes all of their other financial activities perform better, and with less risk.

What are you doing, today, to ensure that you are in a position to take advantage of change, rather than react to it?

John D. Perrings