Will Inflation And The Stock Market Conspire To Kill The 4% Rule?

A recent WSJ headline sent chills down the backs of every retiree—”Cut Your Retirement Spending Now, Says Creator of the 4% Rule.”

In the article, the WSJ quoted the father of the 4% rule, William Bengen, as saying that “there’s no precedent for today’s conditions.” Stock and bond prices are still at record highs. Mix in a reference to 8.5% inflation, and the WSJ starts to sound like an insurance salesperson pitching indexed annuities.

So are things really that bad? And do retirees need to rethink the 4% Rule? I don’t think so, and here’s why.

The 4% Rule is Now the 4.4% Rule

In the article, Mr. Bengen said he believes a safe initial withdrawal rate is 4.4%. Yes, that’s an increase from his initial findings in his 1994 paper.

In his 1994 paper, he assumed retirees invested in the S&P 500 and intermediate Treasury bonds. That’s it. Since then he expanded the asset classes to include mid-cap, small-cap, micro-cap and international stocks. This diversification caused him to increase the safe withdrawal rate from 4% to 4.7%. Because of the unprecedented conditions noted above, however, new retirees might want to start at 4.4%, he said.

As far as I can tell, the 4.4% rate is not based on data. Still, it represents a 10% increase, not decrease, from his initial 4% rule. That doesn’t sound so bad.

“The combination of 8.5% inflation with high stock and bond market valuations make it difficult to forecast whether the standard playbook will work for recent retirees,” said Bengen. He’s even gone so far as put 70% of his personal portfolio in cash. When the father of the 4% rule cashes out, shouldn’t we?

I don’t think so. For starters, it’s important to understand how Bengen developed the 4% Rule. He examined 50-year retirement periods dating back to 1926. For each, he identified the highest withdrawal rate one could take in the first year of retirement, adjusted for inflation in subsequent years, without running out of money for at least 30 years.

As you might imagine, every year had a different initial withdrawal rate. Some years the starting rate was twice what it was in others. Here’s the key point. He didn’t average all of these initial withdrawal rates to come up with the 4% rule. He took the absolute worst year—1968.

Here’s more on how the 4% Rule works.

What does this mean? It means the 4% Rule has survived the stock market crash of 1929, the Great Depression, WWII, the Korean War, the Vietnam War, the inflation of the 1970s and early 1908s, the 1987 market crash, 9/11, the Great Recession and Covid-19.

Stock Prices

No matter how difficult past times have been, current conditions feel awful in ways that history never can. One need look no further than Robert Shiller’s CAPE (cyclically adjusted price-to-earnings ratio) of the S&P 500 to raise concerns. It stands at roughly twice its average and at historic highs. It’s only been higher once, and that was during the tech bubble.

Yet as “unprecedented” as this may seem, it’s not for two reasons. First, most portfolios don’t have the same PE as the S&P 500, even if measured using CAPE. Add in mid-cap, small-cap and international stocks, and the PE comes down significantly.

Second, and more important, the CAPE of the S&P 500 would fall to average with a 50% decline in the S&P 500. This wouldn’t be fun, but it wouldn’t be unprecedented, either.

As noted above, the market lost 90% to kick off the Great Depression. And going back to the tech bubble, the market lost 9%, 12% and 22% from 2000 to 2002. That’s not quite a 50% total loss, but close. And from peak to trough during the Great Recession (2007-2009), the market lost more than 50%. The 4% Rule survived like a cockroach.

Bond Prices and Inflation

Bond yields were at historic lows. I say “were” because that’s no longer the case. The roughly 3% yield on the 10-year Treasury is still below average, but there are plenty of years dating back to the 1800s when they were lower. And when Bengen published his 1994 paper, TIPS were three years away and the first I bond was still four years away. So at least now we can keep up with inflation.

Here’s the key. The 4% Rule has survived Treasury yields as low as 1 to 2%. It also survived inflation of more than 13% and a decade of inflation at 6% or higher. And like the Energizer Bunny, it keeps going and going (or ticking for you Timex fans).

Final Thoughts

Some year might come along that is worse than 1968 for new retirees. Maybe 2022 will turn out to be a worse time to retiree since the late 60s. Perhaps in 30 years we’ll know that for 2022, the initial safe withdrawal rate was 4.2% instead of 4.4%.

But can we really predict that based on current conditions, when the 4% rule has survived much worse? I don’t think so.