Rewriting The 4% Rule

by: Kevin Feldman

In my last post about spending in retirement, I talked about the ubiquitous 4% rule - a popular formula based on withdrawing 4% annually, plus inflation after the first year throughout your retirement years. Depending on your asset allocation, research has demonstrated a very high success rates (95-98%) in terms of not exhausting your retirement portfolio during your retirement. In fact, there have only been two years since 1929 - if you had retired in 1965 or 1966 - where the 4% rule would not have worked well given the long bear market of the 1970s combined with very high inflation. In most cases, the 4% rule achieves the opposite effect: leaving you with very high balances at death, which may also not be desirable unless you are planning a large legacy for your heirs.

In this blog, I wanted to review some of the ways financial planners and economists have proposed amending the 4% rule to optimize portfolio distributions.

Perhaps the most forceful criticism of the rule came in a 2009 paper, The 4% Rule — At What Price?, published in the Journal of Investment Management by Jason S. Scott, William F. Sharpe and John G. Watson. The problem with the 4% rule, these authors write, is that it financed a “constant, non-volatile spending plan using a risky, volatile investment strategy.” In other words, while your portfolio returns inevitably vary, the 4% rule mandates that your withdrawal rate stays the same. “As a result, retirees accumulate unspent surpluses when markets outperform and face spending shortfalls when markets underperform.” A more fluid, customized approach that factored in market fluctuation could help avoid both problems, the authors conclude.

These authors are not alone in questioning how well the 4% rule works based on market performance at the time of retirement. Other researchers have proposed rules-based frameworks that use the current vs. average P/E ratio - as well as other measures - to better forecast expected returns. Using these rules would have allowed sustainable withdrawal rates of 3.5% to 5.5% per year.

Finally, numerous authors have examined how retirement withdrawal rates are affected by when a person retires. What happens if, for example, you retired in January 2009 vs. in January 2008 when the stock market was about 30% higher? In a paper called “Sustainable Withdrawal Rates of Retirees: Is the Recent Economic Crisis a Cause for Concern?,” three authors from the University of Georgia find that if you get hit with a major market slide when or shortly after you retire you are more likely to burn through your savings at “conventional withdrawal rates." Their logical solution: Adjust your withdrawal rates. Economist Wade Donald Pfau comes to a similar conclusion in a paper looking at people who retired in the year 2000, when the tech bubble popped. His conclusion: They may “experience the worst retirement outcomes of any retiree since 1926.”

Is there a safer and simpler way to plan retirement distributions? If you’ve saved more than you need for retirement and can live on 3% plus an inflation adjustment each year, you have the past century of data on your side suggesting that your nest egg will not outlast you. For most of us though, this is an unrealistic drawdown rate, so you will likely need some professional financial planning help to map out a withdrawal plan that meets your retirement goals. Like all rules that try to simplify complex questions, 4% is just that - a number, which may or may not be your number.

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