4% rule for retirees has serious drawbacks

Among the more remarkable numbers these days is the calculation that an estimated 10,000 boomers are turning 65 every day until 2030. Yet in critical ways the financial services industry isn't well prepared for an aging population. The industry has largely focused its efforts on developing products and persuasions geared toward boosting retirement savings. Much less brainpower has gone into devising smart and easy ways for people to turn accumulated savings into a reliable stream of retirement income.

"The financial industry is about to have a 'retirement income' epiphany," said Bill Meyer, head of Retiree Inc., a fintech firm owned by mutual fund company T. Rowe Price, during a recent webinar. "We need more innovation."

Financiers are working at devising better retirement income products and strategies. Meanwhile, the retirees often rely on a handful of guidelines. Best-known is the calculation that retirees can withdraw 4% of their total portfolio savings in their first year of retirement. The 4% base is adjusted annually to take inflation into account. The promise of this approach is that over a 30-year time horizon the odds of running out of money are slim. The 4% rule is also simple to follow.

The 4% rule is a reasonable baseline, but it also has serious drawbacks. Among them: Retirees often want to vary their spending during retirement. Many people don't retire for three decades. Market conditions affect how much you can safely withdraw. For example, the investment data firm Morningstar in 2021 calculated the safe withdrawal rate was 3.3% since market valuations were so high. Morningstar's latest report now says 4% is OK. Higher yields on bonds and cash hike the prospect for improved future returns. A more moderate inflation outlook also helps.

What is the typical retiree to do?

First, the most important decision for the typical worker is when to file for Social Security. The benefit is some 76% higher if you wait to file at age 70 compared to age 62. (That said, filing early is the smart option for people in poor health, caregiving responsibilities, and unemployed.)

Second, as the Morningstar authors note, build flexibility into your safe withdrawal strategy. Several factors should inform your flexible approach, including how much you want to leave to heirs and charity, the extent fixed expenses are covered by other sources of nonportfolio income, lifestyle goals, and how many years you're likely to be retired. The combination of planning and disciplined flexibility pays with designing a household's safe withdrawal strategy.

Chris Farrell is senior economics contributor, "Marketplace"; commentator, Minnesota Public Radio.