Is the 4 percent income rule still safe?

The ability to sustain a steady income during retirement years has always been a primary concern for people in the United States. Recent studies have shown that 61% of U.S residents age 44 to 75 are more afraid of running out of savings/income than they are of death. In order to avoid exhausting a savings nest egg, guidelines have been developed. The most popular is the 4% income rule.

The 4% rule was developed in the early 1990’s by a certified financial planner named William Bengen. He set 4% as the amount of money a retiree can take out of their investments every year with a high probability that it will last for at least 30years. Since that time, financial advisors have been using it as the benchmark with clients.

A recent study from The Journal of Financial Planning has suggested that 4% is no longer a safe number. The study determined that 1.8 % is more appropriate to ensure income does not run out during retirement. The revised rate was based on many market factors. One marker was the historically high price to earnings ratio in the market which may lead to low future investor returns. The risk of poor market timing was also a factor. Taking income at the start of a bear market can have a drastic negative effect on account values and the ability to take future income.

Using a 1.8% model instead of a 4% model may be safe but it has obvious drawbacks. Consider that a person with a $500,000 investment account can only safely pull $9,000 a year from it versus the 4% model which allowed them to take $20,000 a year. If the 1.8% rule is going to be followed, there is an obvious need to increase the investment nest egg prior to retirement which may not be feasible for many people.

An alternative to this approach would be to use a guaranteed insurance contract (GIC) to create the needed income. The advantage of guaranteed contract is the ability to draw a much higher percentage of income on a guaranteed basis. The most competitive GIC’s will currently pay 5.5% to 6.0% income for life on a single life and 5% on a joint life basis. Most contracts do not require forfeiture of the lump sum invested. Some GIC contracts also offer a guaranteed roll up rate during the accumulation period. It is not uncommon for companies to offer a 7% or 8% compound accrual rate for up to 30 years. The guaranteed roll up allows for more precise planning of future asset needs.

While using a GIC can offer many advantages, caution most also be taken. There are hundreds of companies currently offering various bells and whistles on GIC contracts in order to gain market share. Some offer benefits or rates that look appealing but really have little benefit to the consumer. Others will promote incredibly high roll up on accumulation but will then lower the guaranteed income payout. The most important features should be compared prior to choosing a contract in order to obtain the best guarantees available.