3 Percent Is the New 4 Percent

by Jeff C. Johnson

Worried woman

The conventional wisdom, in recent years, was that a retired person could withdraw 4 percent of their retirement account balance annually for income and very likely never deplete their nest egg. Though a good financial plan would go much deeper into the numbers regarding longevity, expected return based on risk, and spending patterns, this old 4 percent rule of thumb has probably worked pretty well.

When looking back over the last several decades since the early 1980s, a typical balanced portfolio of 60 percent equity investments (i.e., stocks or stock mutual funds) and 40 percent fixed-income investments (bonds) has provided retired investors with income and growth. The blended return of this “60/40” portfolio has returned an average of more than 4 percent, supporting the distribution rate.

But something has changed. Over this last, let’s call it 30 years, interest rates have mostly been trending lower. With a few stops along the way, interest rates have descended from well over 10 percent to the low, low single digits. So, with that 40 percent investment in bonds, the investor captured a cash interest payment plus had some exposure to capital gains from bonds because they rise in value as interest rates decline.

But what about the next 30 years? Not only are interest rates low now, generating less in spendable cash, but bond values might decline in price if interest rates rise.

Stock values might also be higher, with less long-term appreciation potential than over the last 30 years. All things considered, the 4 percent distribution that many consider the standard should be reduced to 3 percent.

What is the practical impact for retirement savers? The bottom line is this: You will need quite a lot more money to support your lifestyle. Let’s consider some simple math.

In the 4 percent distribution world, you would need 25 times your desired income in savings and investments. A person desiring $100,000 in income from their portfolio would need $2.5 million in capital. A 4 percent withdrawal rate on that principal would generate the needed $100,000 income.

In the 3 percent era, you would need to save more than 33 times your desired retirement income. $3.3 million invested with 3 percent withdrawal produces the needed $100,000 in cash flow.

Future retirees will be faced with the need to accumulate more money by (a) saving more, (b) starting to invest sooner in life, (c) working longer, and (d) being more informed and/or better advised.