The New Road to Retirement

Retiring soon? Why the popular 4% withdrawal rule may be a bad idea

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Key Points
  • A booming stock market and high long-term unemployment among seniors may lead some Americans to consider retirement.
  • But market peaks are generally the riskiest time to retire, according to researchers. Of course, it's impossible to tell when another pullback will occur.
  • Those who do retire may want to reconsider adhering to the 4% rule for portfolio withdrawals.
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Stocks are booming and seniors are struggling with long-term unemployment.

Taken together, poor job prospects and a healthy nest egg may make it seem like a good time to retire.

In fact, it may be a particularly dangerous time for Americans to do so, according to financial experts.

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And new retirees who aim to use a common strategy — the "4% rule" — to withdraw their funds are in jeopardy of running out of money early, they said.

"The 4% rule is under more risk," Wade Pfau, a professor of retirement income at the American College of Financial Services, said.

Unemployment and stocks

Older workers generally have a harder time finding work during downturns than younger cohorts.

More than half (54%) of the 1.7 million unemployed workers age 55 and over are long-term unemployed, according to AARP, an advocacy group for older Americans. (Economists consider long-term unemployment to be a period exceeding six months.)

By comparison, 41% of workers ages 16-54 are long-term unemployed — which is lower but still high by historical standards.

I'd be cautious to retire after a time when markets have done this well. The odds of that continuing aren't very good.
David Blanchett
head of retirement research at Morningstar Investment Management

The trend among older Americans has occurred even as the unemployment rate among those 55-plus has fallen. (It was 4.5% in March, lower than the 6% national rate.)

However, data suggest some of the drop is due to seniors choosing to leave the labor force and retire, said Jen Schramm, a senior strategic policy advisor in the AARP Public Policy Institute.

Meanwhile, the stock market is near all-time highs.

The S&P 500 stock index is up almost 50% over the past year. It's up 10% so far in 2021.

"People tend to retire at market peaks, not market drops," David Blanchett, the head of retirement research at Morningstar Investment Management, said.

Time for caution

Yet, market peaks are generally among the worst times to retire, experts said.

"I'd be cautious to retire after a time when markets have done this well," Blanchett said. "The odds of that continuing aren't very good."

This is the time when "sequence of return risk" becomes a bigger threat.

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Withdrawing money from stocks to fund retirement during a falling and prolonged bear market leaves less runway for the portfolio to grow when stocks rebound. Pulling out too much in the early days of retirement can cripple a retiree's finances for the later years.

That's why retiring at a market top — right before a pullback — is linked with lower safe withdrawal rates, said Pfau, who has researched the subject.

(In other words, the amount of money retirees can pull from a portfolio with low risk of running out of money goes down.)

The 4% rule

Ariel Skelley | DigitalVision | Getty Images

The 4% rule is an often-cited framework to safely pull money from retirement portfolios.

The metric, created in the 1990s by financial advisor William Bengen, says retirees can withdraw 4% of their total portfolio in the first year of retirement. That dollar amount stays the same each year and rises only with annual inflation. This approach carries low risk of running out of money over a 30-year retirement, according to the rule.

However, the current market environment may mean 4% is too high a safe withdrawal rate for new retirees, experts say.

That's especially true for those with rigid monthly spending needs, they said. Such individuals don't have much flexibility to cut back on discretionary purchases (vacations or eating out, for example) if the market goes sideways.

"If you're someone who has to have a certain amount, 3% is the new 4%," Blanchett said of the 4% rule. "Because you don't have a cushion if things do go poorly."

However, higher withdrawal rates — 4%, 5% or 6%, for example — may be possible if there's room to cut spending, he said.

The 4% framework also assumes over half a retiree's portfolio is held in stocks, which isn't necessarily the case for everyone. It also assumes spending doesn't vary, except with cost of living — but being flexible if market conditions worsen can improve one's outlook, experts said.

There are many other factors built into low-risk withdrawal rates, said Allan Roth, a certified financial planner at Wealth Logic, based in Colorado Springs, Colorado.

Age, health, life expectancy and the amount of guaranteed monthly income from sources like Social Security and pensions (which don't fluctuate with market conditions) are also important considerations, he said.

For example, a shorter life expectancy and a monthly budget that can be covered largely with Social Security income likely means a retiree can pull more money from their investment portfolio safely each year.

Other concerns

But stocks aren't the only concern in the current environment, experts said.

For example, interest rates are low, which hurts returns on bonds and other fixed-income investments.

Some economists have also warned inflation could pick up due to trillions of dollars of Covid stimulus money that's been pumped into the economy. If it occurs, higher inflation may erode retirees' purchasing power and push officials to raise interest rates, which would reduce bond yields in the short term, experts said.

"Is inflation a possibility? Yes. But is it a definite? No," Roth said.

It's also impossible to predict how well the stock market will or won't do in the near term.

Stocks had been on an 11-year winning streak, the longest in modern history, before the coronavirus pandemic tipped it into a bear market in March 2020. It was followed by the quickest recovery in history.

"I'm not forecasting a downturn," Pfau said. "But there's certainly a greater risk of a downturn."