Bill Bengen, the retired researcher who developed the famous 4% rule, has a message for early retirees: You may be living more frugally than necessary.
“I think they’re kidding themselves a little bit,” Bengen told CNBC’s Make It about retirees who strictly followed his original guidance(1).
The problem is not that Bengen’s research is wrong. Instead, he believes many retirees focus on a static percentage — 4 percent, or his updated version of 4.7 percent — without taking into account economic and market conditions that determine whether withdrawals can safely be raised or should be more cautious.
This background is especially important for early retirees. Retiring at 45 or 50 means managing a portfolio for 40 to 50 years, so the distinction between unnecessary life restrictions and sustainable spending is critical.
Bengen’s 4% rule, originally published in 1994, suggests that retirees can withdraw 4% of their portfolio in the first year and then adjust that dollar amount each year for inflation without running out of money within 30 years. His latest research recommends a 30-year retirement age of 4.7% and a 50-year retirement age of 4.2% (1).
But these numbers represent a worst-case scenario: Withdrawal rates hold true even for retirees entering retirement during one of the most challenging times in financial history.
“My research shows that if you go through a severe bear market early in retirement, it lowers your withdrawal rates because it sucks a lot of stuff out of the portfolio at the same time you’re withdrawing it,” Bengen explained to CNBC(1).
Just as important, if you avoid these worst-case scenarios, you may be able to withdraw more money.
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So how do early retirees tell if they are being too conservative? Bengen points to some economic and market indicators that can inform exit decisions:
Market valuation at the start of retirement. Stock market valuations strongly influence future returns. Shiller CAPE (cyclically adjusted price-to-earnings ratio) provides a measure that divides current prices by 10-year average inflation-adjusted earnings. According to GuruFocus data, the S&P 500 Shiller CAPE ratio was around 40 (2) in December.
That’s well above the historical median of 16 and close to levels seen during the dot-com bubble in the late 1990s. High valuations often portend lower returns in the future, suggesting caution for those retiring today. Conversely, retirees who initiate withdrawals when valuations are moderate or low have historically been able to safely use higher withdrawal rates.
Inflation trends matter. Rapidly rising costs erode purchasing power and could force retirees to withdraw more funds or cut back on spending. According to the St. Louis Federal Reserve(3), the current inflation rate of 2.8% remains above the Fed’s 2% target. Early retirees should keep a close eye on inflation, as persistently high inflation favors more conservative initial withdrawals.
Interest rates and bond yields. Bengen’s latest research assumes a portfolio of 45% in bonds and 5% in cash(1). When bond yields are higher, the tranche generates more income, supporting a higher overall withdrawal rate. But when yields are suppressed, retirees may need to be more careful with withdrawals.
Yields have now normalized from pandemic-era lows but remain below historical averages, creating a moderately supportive environment for withdrawals.
Sequence of return risk. The sequence of return on investment is very important. Strong returns early in retirement can provide a cushion that allows for larger withdrawals. Poor returns in the first few years can create “holes” in a portfolio that may be difficult to recover from.
This uncertainty means retirees should re-evaluate withdrawal rates regularly rather than setting them once and forgetting about them.
Flexibility benefits early retirees. Unlike traditional retirees who may have fixed expenses and limited ability to return to work, early retirees generally have more options. For example:
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You can reduce discretionary spending during a market downturn.
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If you want, you can earn income through consulting, part-time work, or side projects.
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If necessary, you can downsize your living environment.
The more flexible you are with your spending and the more options you keep, the more aggressive you can be with your initial withdrawal rate because you’ll have options if things go south.
For early retirees who question whether their withdrawals are too conservative, Bengen’s research recommends asking these key questions:
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1. What will the market valuation be when you retire? If you start taking withdrawals when a stock is reasonably priced or undervalued, you may have more room than you think.
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2. How will your investment portfolio perform in early retirement? Strong initial returns can build a cushion. If your earnings are above average in the first few years, you may be limiting your spending unnecessarily.
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3. How flexible are your expenses? If you can cut your spending by about 20% to 30% during a downturn, you may be able to afford higher baseline withdrawals.
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4. What is your earning potential? Early retirees with marketable skills and a willingness to earn an income sometimes exit more aggressively than those without a backup plan.
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5. How is your health and family longevity? Someone who retires at 45 with good health and a family history of longevity should be more conservative than someone who retires at 55 with significant health challenges.
Retiring early requires planning for a longer time horizon. While it’s not pleasant to think about, realistic life expectancy is another key factor for early retirees to consider.
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CNBC(1); Guru Focus(2); Federal Reserve Bank of St. Louis(3)
This article provides information only and should not be considered advice. It is provided without any warranty of any kind.
