Rules are meant to be broken, right?
Recent research is challenging two commonly accepted principles of retirement savings: the 4% withdrawal guideline and the 60-40 investment portfolio. While these guidelines can serve as useful starting points for discussions, they may not suit everyone’s financial situation, as indicated by two new reports.
The first report from a financial research firm suggests that, in most cases, you should withdraw even less than the traditional 4% guideline from your retirement savings. Additionally, a 2023 study that gained significant attention on the research network SSRN advocates for a much more aggressive stock allocation in your retirement portfolio, positing that this approach is actually safer than the conventional 60/40 portfolio strategy.
Let’s delve deeper into these findings.
Understanding the 4% Withdrawal Rule for Retirement
In 1994, financial planner William Bengen published groundbreaking research in the Journal of Financial Planning that introduced the now-iconic 4% rule. This guideline proposed that retirees should aim to withdraw 4% of their initial savings annually, with adjustments made each year for inflation. This rule was designed to ensure that your retirement savings would survive for at least 30 years.
The premise behind the “Bengen rule” is that if you retire at age 65, withdrawing 4% annually should see your funds last until you reach 95. Despite the popularity of this rule over the last three decades, new data from Morningstar, an investment research firm, indicates that your “safe” withdrawal rate actually depends on both your retirement duration and the asset allocation of your portfolio.
According to Morningstar’s research, for a typical 30-year retirement with a stock allocation ranging from 20% to 50%, the ideal withdrawal rate is closer to 3.7%. Generally, this means that the longer you expect to be retired and the higher your stock allocation, the less you should withdraw each year.
For instance, if you’re planning for a 20-year retirement, a withdrawal rate of 5% may be sustainable. In contrast, for a 40-year retirement, Morningstar advises limiting your withdrawals to no more than 3.1%. If you opt for a highly aggressive investment strategy, as some studies suggest, you might consider withdrawing even less—potentially as little as 2.7% annually.
Rethinking the 60/40 Retirement Investment Portfolio Strategy
As you approach retirement, many financial advisors typically advocate for a gradually conservative investment approach. This often includes starting with the traditional 60% stocks and 40% bonds (commonly referred to as a 60/40 portfolio) and then reallocating more toward bonds as you age. However, a recent controversial study conducted by finance professors from Emory University, The University of Arizona, and The University of Missouri challenges this approach.
The researchers found that a portfolio consisting entirely of stocks significantly outperforms the conventional 60/40 strategy. They advocate for a strategy that allocates 33% to U.S. stocks and 67% to international stocks, promoting a 100% equity approach. It’s a bold recommendation: invest entirely in stocks, with no bonds in sight.
This study concluded that an all-stock portfolio “vastly outperforms” other types of portfolios in various aspects, including wealth accumulation, preservation during retirement, and the ability to leave inheritances. In other words, if you are looking to maintain a substantial amount of retirement savings to pass on after you’re gone, this strategy shows promise.
The authors compared several portfolio options using a hypothetical couple who began saving for retirement at age 25. They found that an all-equity strategy not only allows for lower savings rates before retirement but also yields significantly higher returns.
For equivalent retirement wealth, individuals would need to contribute 16.1% of their income into a target-date fund or 19.3% into a 60/40 portfolio to match the wealth generated by a 10% savings rate in an all-equity portfolio. Moreover, when savings rates were equal, the all-equity strategy produced 50% more wealth than the 60/40 approach and 39% more than target-date funds.
However, it’s essential to consider the potential downsides. Stocks are notoriously volatile, and a 100%-stock portfolio can lead to significant psychological distress during market downturns. The authors caution that some investors might panic and abandon their investments rather than staying committed through market fluctuations.
Nevertheless, they argue that other investment strategies can also be volatile and might even pose a greater risk of outliving one’s savings. Therefore, while their findings do not imply that an all-equity strategy is without risks, they suggest that it may be a safer alternative compared to more traditional methods.
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