The 4% Retirement-Asset Spend-Down Rule Is Rubbish

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Summary

The 4 percent retirement-asset spend-down rule, like the replacement-rate rule, is a rule of dumb, not a useful rule of thumb.
Using it to set your retirement spending is dangerous. It can easily lead to serious over- or under-spending.
This is not 1950. We have math, algorithms, high speed computers. We don't need to guess what to spend in order to achieve a stable living standard.
We can calculate the right answer in seconds.

Conventional financial planning uses two rules of thumb. One is the 70 percent replacement-rate, retirement-spending rule. The other is the 4 percent retirement-asset, spend-down rule. The replacement-rate rule says you need to accumulate enough assets to be able to spend 70 percent of your pre-retirement income in retirement. The 4 percent rule says you should withdraw and spend an amount equal to 4 percent of the retirement account balances you held when you first retired. Whether these two rules, both of which tell you what to spend in retirement, are mutually compatible is a good, but apparently never posed question to which I'll return in a subsequent column.

Today's article rubbishes, as the Brits say, the 4 percent rule. This article from last week rubbished the replacement rate rule. As it pointed out, the right replacement rate is based on the spending level that provides the household with the same living standard post-retirement as it enjoyed pre-retirement. The desire to have a stable lifestyle, i.e., to preserve our living standard, is what economists call consumption smoothing. It's why we save in the first place.

Given a household's current and future resources and the time pattern of those resources, one can solve for the precise spending path in all future years - pre- and post-retirement, which delivers the smoothest stable living-standard path subject to the household's year-specific cash constraints, i.e., subject to keeping the household out of debt or out of more debt.

My company's Smarter Personal Financial and Retirement Planning Software | MaxiFi Planner makes this calculation. It's the only tool that does consumption smoothing subject to cash constraints. I developed it originally to do academic research, but saw early on that it could be used to provide households with personalized financial guidance. I and my colleagues have now spent a quarter century developing the tool. There is a single solution to the problem being solved. The tool finds it in a few seconds. But it took 25 years to sort out the algorithm and get all the critical details (e.g., federal and state taxes, Social Security benefits) right.

I point this out to make clear that there is no need to guess a client's or one's own replacement rate. One can figure it out quickly and precisely. In the prior article, I used the program to calculate the right annual spending for typical households and compare the implied replacement rates with 70 percent. The right rates were more often than not miles off from 70 percent.

But does using the wrong replacement rate matter? It sure does. Say you use 70 percent when the right figure is 80 percent. You'll be induced to significantly undersave. Alternatively, the right replacement case may be 60 percent, but you use 70 percent. In this case you'll be led to significantly oversave. Why "significantly?" Because being off by 10 percentage points for the roughly 35 years of your possible retirement means under-estimating or over-estimating cumulative retirement spending by a mile. This, in turn, will lead you to the wrong amounts each and every year before retirement.

Furthermore, even if a financial advisor were, by Divine providence, to come up with the right retirement-spending level (i.e., the right replacement rate), she would need to translate that into an annual pre-retirement spending and saving plan. But this requires the advisor to properly set the client's pre-retirement spending each year to keep the client's living standard stable in light of annual changes in income, housing costs, support of children, tuition payments, alimony, taxes, etc.

This isn't what planners do. Instead, they tell clients to save the same amount (or the same percentage of their incomes) each year straight through retirement. But this means their clients will experience a drop (rise) in their living standards when their incomes are temporarily low (high) or their off-the-top expenses are temporarily high (low).

This is the antithesis of consumption smoothing.

Ok, enough on the replacement rate. What about the 4 percent rule? According to Investopedia:

The 4 percent rule is a rule of thumb used to determine how much a retiree should withdraw from a retirement account each year. This rule seeks to provide a steady income stream to the retiree while also maintaining an account balance that keeps income flowing through retirement.

I've tried for years to wrap my brain around this "rule" and am still perplexed. Withdrawing a steady amount (adjusted for inflation) is a simple calculation one can make in Excel. You just need to specify start and stop dates and a rate of return. So "steady income stream" must really reference steady spending. In this case, the rule is focused on steady annual spending as a share of initial retirement assets.

To evaluate whether this ratio is anywhere close to 4 percent, I again used www.maxifi.com to consider a typical household. My pretend couple is age 66, married, has $500,000 in regular assets and $1 million each in retirement accounts. Their house is paid off, but their annual property, insurance and maintenance costs total $14,000. Each spouse just filed to collect a $2,500 monthly Social Security retirement benefit and each spouse just initiated annual smooth retirement account withdrawals. The couple earns 1 percent real on their regular assets and 2.5 percent real on their retirement accounts.

Let's call this couple the Saunders. What's the Saunders' proper spending rule? Is it 4 percent of their age-66 assets? No, it's 6.2. If they have $2 million in regular assets it's 5.3. If they have zero regular assets and $275,000 each in retirement accounts, their spending rule is 10.5 percent.

I could go on. The point is that spending rule is so extraordinarily sensitive to the household's precise situation as to be useless. And like the replacement-rate rule, choosing one's spending rule based on a rule of thumb is incredibly dangerous. It can lead households to either run out of money, suffering a severe decline in their living standard, or leave far too much money on the table when they pass away.

This is not 1950 or whenever these rules of thumb were first developed. We can do the math, we can solve the problem. We have the algorithms and high-speed computers. There is no reason to guess about what to spend this year or in the future. Using either the replacement-rate or 4 percent rules of thumb to manage your own or someone else's finances is akin to setting a tractor trailer on cruise control and taking a nap. That too is a rule of dumb.

This article was written by

Laurence Kotlikoff

1.11K Followers

Laurence J. Kotlikoff is a William Fairfield Warren Professor at Boston University, a Professor of Economics at Boston University, a Fellow of the American Academy of Arts and Sciences, a Fellow of the Econometric Society, a Research Associate of the National Bureau of Economic Research, Head of International Department for Fiscal Sustainability Studies, the Gaidar Institute, President of Economic Security Planning, Inc., a company specializing in financial planning software, and the Director of the Fiscal Analysis Center. Professor Kotlikoff is a NY Times Best Selling author and an active columnist. His columns and blogs have appeared in The New York Times, The Wall Street Journal, The Financial Times, the Boston Globe, Bloomberg, Forbes, Vox, The Economist, Yahoo.com, Huffington Post and other major publications. In addition, he is a frequent guest on major television and radio stations. In 2014, he was named by The Economist as one of the world's 25 most influential economists. In 2015 he was name one of the 50 most influential people in Aging by Next Avenue. Professor Kotlikoff received his B.A. in Economics from the University of Pennsylvania in 1973 and his Ph.D. in Economics from Harvard University in 1977. From 1977 through 1983 he served on the faculties of economics of the University of California, Los Angeles and Yale University. In 1981-82 Professor Kotlikoff was a Senior Economist with the President's Council of Economic Advisers. Professor Kotlikoff is author or co-author of 19 books and hundreds of professional journal articles. His most recent book, Get What's Yours -- the Secrets of Maxing Out Your Social Security Benefits (co-authored with Philip Moeller and Paul Solman, Simon & Schuster) is a runaway New York Times Best Seller. His other recent books are The Clash of Generations (co-authored with Scott Burns, MIT Press), The Economic Consequences of the Vickers Commission (Civitas), Jimmy Stewart Is Dead (John Wiley & Sons), Spend ‘Til the End, (co-authored with Scott Burns, Simon & Schuster), The Healthcare Fix (MIT Press), The Coming Generational Storm (co-authored with Scott Burns, MIT Press), and Generational Policy (MIT Press). Through his company, Professor Kotlikoff has designed the nation's top-ranked personal financial planning software and Social Security lifetime benefit maximization software. Professor Kotlikoff has served as a consultant to the International Monetary Fund, the World Bank, the Harvard Institute for International Development, the Organization for Economic Cooperation and Development, the Swedish Ministry of Finance, the Norwegian Ministry of Finance, the Bank of Italy, the Bank of Japan, the Bank of England, the Government of Russia, the Government of Ukraine, the Government of Bolivia, the Government of Bulgaria, the Treasury of New Zealand, the Office of Management and Budget, the U.S. Department of Education, the U.S. Department of Labor, the Joint Committee on Taxation, The Commonwealth of Massachusetts, The American Council of Life Insurance, Merrill Lynch, Fidelity Investments, AT&T, AON Corp., and other major U.S. corporations. He has provided expert testimony on numerous occasions to committees of Congress including the Senate Finance Committee, the House Ways and Means Committee, and the Joint Economic Committee.

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