Traditionally, financial advisers, savers, and retirees have relied on the 4% rule to determine how much to save for retirement and what kind of annual income their retirement savings would provide. This rule was first proposed in the 1990s.
Discovery notes that the 4% rule suggests that retirees can withdraw 4% of their savings annually, adjusting this amount for inflation each year, and their savings should last at least 30 years. According to this rule, retirement savings should be equally split between stocks and bonds.
This approach also helps investors calculate the lump sum needed to generate an acceptable annual income in retirement.
For instance, if you are retiring today with a final salary of R480,000 per year and you need 90% of this amount as a replacement ratio, you would need R432,000 annually.
To ensure that your retirement capital lasts for 30 years, R432,000 should represent 4% of your total savings. Therefore, you would need R10.8 million in savings to withdraw 4% or R432,000 annually.
Put another way:
You need R432 000 a year (90% of R480 000).
R432 000 must be 4% of your total savings at retirement if you don’t want to deplete your nest egg.
R432 000 is 4% of R10.8 million
Therefore, you need R10.8 million saved at retirement to give you R432 000 a year.
Does it have relevance in a new century?
This retirement theory is not without its critics. Those who question the 4% rule’s relevance say it doesn’t take into account issues such as taxes or varying investment horizons, and also observe that financial conditions when the rule was formulated were very different to the reality in this century.
For example, Bengen’s rule is based on the average long-term annual returns (since 1926) of shares and bonds being 10% and 5.3%, respectively.
According to CNBC, 61% of financial advisors are still using the 4% withdrawal rule, citing research from David Blanchett, managing director and head of retirement research at PGIM DC Solutions.
“The 4% rule started in the US in the 1990s when interest rates were a lot higher. With rates at an all-time low, the rule has broken down there – another reason to not use rules in planning,” says Craig Gradidge, investment specialist/director at Gradidge-Mahura Investments.
“In South Africa, rates and dividend yields are low, but still high enough to sustain the rule, but that could also change in time – and highlights the pitfalls of following any rules when planning for retirement."
And a 2010 paper by Wade Pfau pointed out that the “US enjoyed a particularly favourable climate for asset returns in the twentieth century” and argued that “from an international perspective, a 4% real withdrawal rate is surprisingly risky.”
Tracy Jensen, Product Architect at 10X Investments, says although “the 4% rule still applies to retirement investing,” it needs to be applied differently in South Africa.
“While the 4% rule still applies to retirement investing, South Africa is unique in the sense that regulations restrict the income drawn each year, between 2.5% to 17.5% of your investment balance. As a result, investors could have sufficient money to draw the income they desire but are restricted once they reach the 17.5% cap. Therefore, an adaptation of the rule is required in our context.”
Gradidge also adds that while the basis of the 4% rule is sound, it still might not be relevant to many would-be retirees. “The 4% rule is simple mathematics; the less you draw from your capital, the longer the capital will last. Given historical data, the 4% rule suggests that capital can last into perpetuity if the investor only withdraws 4% of capital as income.
"Mathematically, this is true. Practically, however, the majority of people have not saved sufficient capital to allow them to take advantage of the mathematics.”
Using the table below, someone who earns an investment return of 7,5% on their investment and uses a drawdown rate of 7,5% can expect to receive a real level of income (that takes inflation into account) for 10 years before their level of income starts to quickly diminish, Discovery pointed out.
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