Sasha Planting
3 minute read
5 Apr 2014
6:00 am

Is 4% the magic formula?

Sasha Planting

A lot of discussion in the US has recently centred on the continued validity of the 4% rule.

Image courtesy stock.xchnge (KillR-B)

Not having a clue what this was, I looked it up. It turns out it’s a rule that retirees have used in the US and elsewhere since the mid nineties to guide their financial planning.

The rule says that if retirees withdraw 4% of their nest eggs in the first year of retirement and adjust that amount for inflation thereafter, their money would last at least 30 years.

Such estimates are crucial to figuring out how much of one’s retirement savings one can spend to make it through retirement without running out of money.

But it seems the rule is out of touch with the economic realities of low returns. California-based financial planner William Bengen crunched the numbers in 1994. Now he’s retired and wondering if his research, groundbreaking as it was, is still applicable.

According to a recent article published on CNBC.com, artificially low interest rates and exaggerated stock market volatility could make the 4% rule outdated.

There’s also uncertainty about future returns. If the stock market isn’t as lucrative in the next few decades as it has been, on average, for the past century, the 4% rule will be too aggressive.

I asked Tracy Jensen, product architect at 10X Investments, for her views on the 4% rule in the South African context.

She says the rule is a useful starting point, but there are many other factors you need to take into account.

For a start, the rule only applies to retirement products where your money remains invested at retirement – in other words a living annuity.

South Africa is also unique in that regulation restricts the income drawn each year to a minimum of 2.5% and maximum of 17.5% of your investment balance. So it’s important to include this capitation when testing the rule.

Jensen adds you can’t determine a sustainable income without considering fees. Investors need to calculate the gross drawdown percentage – the income plus all fees expressed as a percentage of the retirement pot.

Life expectancy should also be factored in. It’s impossible to know exactly how much life you have left. If your family consists of centenarians, though, a lower withdrawal rate would be wise.

Your ideal withdrawal rate depends heavily on your portfolio’s growth rate. South Africans tend to have a higher proportion of their portfolios in bonds, says Jensen. Conservative portfolios can’t grow as rapidly as aggressive portfolios, in which stocks make up the majority. Therefore, conservative investors should withdraw less, assuming their stocks are performing.

Remember that past stock market performance is no guarantee of future performance. And you may have to adapt on the fly.

The rule of thumb in SA, says Jensen, is that your gross drawdown percentage should be about 5% if you want your income to grow with inflation over a period of 30 years. But remember, if your annual fees are 2.5%, you are taking home just half of that 5%.

For every 1% in fees you save each year pre-retirement (as a percentage of your investment balance), you will have 30% more income in retirement.

A big enough nest egg would equate to at least 15% of your gross salary over 40 years. This should give you an income of approximately 60% of your final salary.

If you are saving for 30 years, instead of 40, you need to increase your savings from 15% to about 25% of your gross salary.