For those in retirement who either don’t have a significant pension pot or aren’t set up to receive a steady stream of income from their investments, drawing on their capital may be the only solution to supplementing the state pension.

The question is, how much should they withdraw each year, and should they vary the amount given investments can go down as well as up in value and inflation is running at record levels?

We look at the academic approach to answering these questions and then apply some real-world scenarios.

WHAT IS THE 4% RULE?

In 1994, US academic William Bengen published a paper in the Journal of Financial Planning using historical stock market data to work out the maximum ‘safe’ annual withdrawal rate as a percentage of a retirement portfolio, along with the optimum mix of bonds and equities.

Bengen based his analysis on US asset prices from 1926 to 1976, during which time stocks returned 10.3% per year, US government bonds returned 5.1% per year and inflation averaged 3.1% per year.

This 50-year period also included three major financial events – the market crash of 1929 to 1931, when stocks lost 60% of their value, the subsequent decline from 1937 to 1941, when stocks lost 33%, and the sell-off of 1973 to 1974, when stocks fell 37%.

Using a mix of 50% stocks and 50% bonds, and assuming the retiree wanted their portfolio to last a minimum 30 years, Bengen calculated that the safest amount to withdraw was 4% in the first year followed by 4% adjusted for inflation in each successive year.

Hence ‘the 4% rule’ was born, and pension advisers have been using the same rule more or less ever since.

HOW USEFUL IS THE RULE TODAY?

There are two major factors in Bengen’s model which can ‘upset the applecart’ in terms of its overall usefulness – expected stock market returns and inflation.

As we well know, markets can go down as well as up and since 1976 there have been several more major financial events which have wiped 30% or more off investors’ portfolios.

For most people the losses are theoretical as they don’t have to sell, but for retirees who are withdrawing money from their pot the losses
are very real.

Even so, Bengen calculated that with a 50% weighting in stocks the typical investor saw a quick rebound in their portfolio so that the overall impact of major sell-offs washed out over a 30-year period.

Surprisingly, the most painful sell-off was not the crash of 1929 to 1931 but the 1973 to 1974 decline, because it coincided with a period of high inflation (over 20%), which meant the purchasing power of what was left in retirement portfolios was substantially reduced.

In fact, the crash of 1929 to 1931 was accompanied by a fall of more than 15% in inflation, which meant that although the value of retirement portfolios fell a lot more, purchasing power was to some degree protected.

While UK inflation today is running at close to 10%, over the longer term it is likely to return to mid-to-low single digits, although we suspect there is little chance of it returning to the Bank of England’s target of 2% any time soon.

Assuming a long-term inflation rate of 5%, for the sake of argument, that means investors who decide to use ‘the 4% rule’ would increase their annual withdrawal by 5% each year.

Importantly, all else being equal, the effect of increasing the withdrawal by the rate of inflation actually makes very little difference to the size of the remaining ‘pot’, as the table shows, but it could make all the difference to a retiree.

IS THERE A CASE FOR VARYING THE AMOUNT?

There has been a great deal of discussion recently – mostly due to the spike in inflation – about the need to take a more flexible approach to drawdown.

According to a December 2021 survey by Dutch life insurer Aegon, half of financial advisers use modelling tools when advising clients on income drawdown, but only a quarter use a fixed-rate method, down from two thirds in 2018, and where a fixed rate is used it is typically higher than 4% but lower than 5%.

‘There has been a huge shift in the methods advisers use to determine a “safe” income drawdown rate in retirement in recent years,’ says pensions director Steven Cameron.

‘Modelling tools overtook the fixed-rate method for the first time following the onset of the pandemic and the latest research shows there has been a further widening of this gap.

‘With the cost-of-living crisis taking hold, some people might look to draw down a higher income from their pension to compensate for rising prices.’

Even William Bengen himself has changed his mind on the appropriate level of withdrawal, and now recommends 4.7% as a ‘safe’ level, although he has changed his model to include a third asset class, small and micro-cap stocks, which typically generate higher returns.

He is quoted as saying his original 4% recommendation was based on an imaginary ‘worst-case scenario of an investor who retired in October 1968 who ran into a terrible, perfect storm of bad stock market results and very high inflation, which forces up withdrawals every year’.

Interviewed in late 2022, Bengen suggested: ‘Investors might consider taking 4.5% at this time when retiring, until the smoke clears and we get a sense of where inflation is going. Inflation is the big wild card in this environment.’

However, he cautioned that trying to beat inflation by adding more asset classes to a portfolio – particularly riskier assets – would likely increase the volatility of returns but probably wouldn’t increase the withdrawal rate by ‘a heck of a lot more’.

ONE SIZE DOESN’T FIT ALL

The bottom line is, like many things in life, planning how much money you are going to need in retirement isn’t easy and the 4% rule isn’t going to suit everybody.

It’s probably a good starting point, however, and anyone approaching retirement and thinking of drawing down their capital should run some numbers to see what they think is a reasonable figure (for ease we have used a £100,000 retirement pot in our examples, which can be scaled up easily).

Also, if you can plan your spending in advance then there are likely to be years when you can withdraw more than 4% and years when you can take less.

It’s worth making two final points. First, Bengen’s model assumes all retirees are happy with a 50% weighting in stocks, and while this may not be the case for everyone it is important to remember that stocks perform better than bonds over the long term once dividends are reinvested, so altering the mix will alter the returns and therefore the amount you can afford to withdraw each year.

Second, Bengen’s model doesn’t account for platform fees, management fees (in the case of funds and investment trusts) or dealing costs, so to end up with 4% net of expenses will cost more than that in reality.

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