can the 4 Per Cent Rule survive stagflation?

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Strolling lottery vendors are one quaint aspect of Spanish street life. Their sheaves of tickets attract customers looking for the “lucky” number that each hopes will dispel all financial worries. Favoured numbers often end in five, a feature of some previous jackpot-winning tickets.

In the UK, four is more commonly the magic digit for anxious retirees who are starting to liquidate investments to live on. It is enshrined in the 4 Per Cent Rule, a popular guideline for financial planning. This faces a tough test if economic conditions deteriorate into extended stagflation amid oil price shocks.

After decades of accumulating assets, private investors with retirement funds need a strategy for decumulation. They fear running out of money within unpredictable remaining lifespans. But they do not want to underspend, either.

The 4 Per Cent Rule, devised by US financial adviser William Bengen in 1994, provides an apparently easy solution to that puzzle: draw down 4 per cent of your fund in the first year of retirement. In each subsequent year, adjust the prior year’s withdrawal by inflation and take out that amount. You should be safely on track for the next 30 years, supposedly.

I am on the cusp of decumulation myself. First contact with the 4 Per Cent Rule therefore tempted me to cry “eureka!” like Archimedes — though without running into the street naked, as the mathematician reputedly did. 

Then my journalist’s natural distrust of everyone and everything kicked in. How well does the 4 Per Cent Rule stand up to stress testing? In particular, what results does it produce during a period of stagflation, defined by sluggish growth, market volatility and sharp falls in the spending power of money?

First, I investigated the basic proposition of the 4 Per Cent Rule using a simple drawdown calculator.

A fund of £500,000 inevitably yielded a £20,000 income in the first year of drawdown. I uprated subsequent withdrawals by 2 per cent, optimistically assuming the Bank of England could hit its perennial target. Then I tested a key vulnerability of the rule: weak investment returns.

Even at a feeble annual payback of 3 per cent after costs, the fund only reached zero in year 29. That is decent going, given that a typical retirement lasts just over 20 years. At slightly higher rates of return, substantial funds would remain. A death-defying retiree, whose portfolio made net returns of 5 per cent a year, would be left sitting on over £400,000 after three decades.

I watered down my faith in the Old Lady of Threadneedle Street for my next experiment. Suppose inflation busted along at 4 per cent a year and investment growth was the same? Withdrawals would more than double in nominal terms by Year 24, reducing the fund to zero shortly afterwards.

That scenario whiffed of stagflation. The logical follow-up was to see how well the 4 Per Cent Rule would have served someone retiring just before the era-defining advent of stagflation in the UK in the 1970s. For me, this decade is usually best forgotten for its terrible economics, casual racism and penchant for beige motor cars. But I figured the back test might provide precautionary pointers to our mooted stagflationary future.

I assumed our retiree quit work in 1969. I kept the arbitrary starting fund value of £500,000 — while vaguely recalling that only The Queen and Rod Stewart had that kind of money back then. I deducted withdrawals uprated at hair-raising historic levels of inflation from a portfolio with 60/40 exposure to UK equities and gilts.

I call the resulting decumulation plot “Profile of a Screaming Investor,” which is what it reminds me of when rotated a quarter turn anticlockwise. Investments soared during the eighties. But that was not enough to spare our retiree from the impact of stock market collapses in 1973 and 1974, triggered by a Middle East war and subsequent oil embargo. The fund was exhausted after 19 years.

There is a jargon phrase for an early hit from which a portfolio never fully recovers: “sequence risk”. Investors are particularly exposed to it during decumulation. The 4 Per Cent Rule is a dangerous doctrine in such circumstances, albeit that 1970s stagflation was extreme.

“The figures show how damaging stagflation can be,” says Charlene Young of investment platform AJ Bell. “Most people are familiar with the benefits of compound returns, but withdrawals during downturns can work the opposite way, in effect locking in losses.”

To be fair, Bengen recognised this in his 1994 paper, which is pragmatic and nuanced. The 4 Per Cent Rule is “a starting point . . . not a silver bullet,” as a later researcher put it. Maintaining spending power today may mean struggling to cover costs later on. If asset prices are crashing and inflation is soaring, retirees should consider withdrawing less than inflationary uprating would dictate. 

The problem with the 4 Per Cent Rule in unqualified form is that it can “oversimplify what is one of the most complex financial decisions people will ever make,” warns Ed Monk of Fidelity International, the investments group. “The original rule was based on historic [US] market data and the idea of a 30-year retirement,” he adds. “Neither assumption reflects the outlook for many of today’s retirees.”

Blind faith in a magic number is fine if you are having a flutter on the streets of Madrid or Seville. In decumulation, it is best to stay flexible.

Jonathan Guthrie is a journalist, adviser and author of ‘The Truth About Investing’. [email protected]