Is the 4 percent retirement rule still relevant in today’s market?

You likely have worked most of your life saving up for retirement. And as you plan to retire, you need to think about how you will take the money you’ve saved and convert it into income for the rest of your life.

If you’re nearing retirement, you have probably heard about the 4 percent rule. Four percent has long been considered a safe retirement withdrawal rate.

According to the rule, if someone’s investment portfolio is equally split between stocks and bonds, they can withdraw 4 percent of their savings during the first year of retirement and have their savings last for 30 years. As a part of the rule, after the first year of retirement the withdrawal amount is increased annually to account for inflation, regardless of how the market is doing.

The 4 percent rule comes from a 1994 study that looked at how much retirees could withdraw from savings without running out of money before the end of retirement. The study found that a 4 percent withdrawal in the first year was the highest rate that held up over a 30-year period. And over the past 150 years, there has never been a 30-year period when someone following the rule would have run out of money.

Of course, just because the rule held up in the past doesn’t guarantee it for the future. Today, there are arguments that the 4 percent rule is not safe enough.

Specifically, there are doubts that the rule will hold up for individuals who retired in 2000. These individuals experienced two significant drops in the market early in retirement. And unlike past time periods when retirees experienced significant drops, today’s market is overvalued for both stocks and bonds. Because of this, many in the industry expect lower future returns, which will put more pressure on retiree’s portfolios going forward.

On the other side, some experts argue that the 4 percent rule is too strict and may result in significant underspending. The idea of having a large savings late in retirement may not seem like reason to worry, but not running out of savings should not be your only goal in retirement. You also deserve to live well on the money you worked to earn.

Here are a few questions to consider to help determine if a four percent withdrawal rate may be too aggressive, too safe, or just right.

Does 4 percent cover all expenses?

First, you need to identify what your expenses in retirement will be and just how much these expenses will cost. You should review how much you currently spend on bills, food, gas, etc. each year.

Then, consider additional expenses you may have in retirement, such as additional travel, eating out more often and medical care. Add your current and estimated future expenses together to determine how much you will need annually, and if 4 percent of your savings would cover that amount. If not, you may have to withdraw more annually. However, if more is withdrawn, there is less certainty that it will last throughout your life.

What is the expected length of your retirement?

The 4 percent rule was tested against 30-year retirements. So, if you plan on working later in life and holding off on withdrawing savings, you may spend less time in retirement. A period of 20 years in retirement actually supports a higher withdrawal rate. Generally, the shorter your time horizon for retirement, the higher the safe withdrawal rate will be.

What is your asset allocation?

The 4 percent rule requires about half of your portfolio to be invested in stocks at retirement. Generally, the higher the withdrawal rate, the higher the exposure to stocks will need to be.

However, the worst thing you can do is build a portfolio that is too aggressive for your own risk tolerance and then stray from that allocation during market volatility.  That turns fluctuations in the value of your portfolio into portfolio loss. If your risk tolerance is lower, you may want to start with a lower withdrawal rate instead.

Overall, the 4 percent rule should not be a fixed, set it and forget it strategy. As with your portfolio throughout your working career, you should review asset allocation regularly. And while the rule recommends retirees adjust the original 4 percent for inflation, a better approach may be to adjust withdrawals each year based on actual portfolio performance.

However, one should take caution if retiring during a period of excessive market valuations. High valuations are good predictors of poor performance for the 10- to-15-year future. During these times, it may be prudent to start with a lower withdrawal rate and reduce equity exposure to protect yourself against risk. From there, one can adjust as necessary depending on actual market performance.

Matthew Anderson is a senior vice president and financial planner with The Wise Investor Group at Robert W. Baird & Co. in Reston..