The Reasons Why We Don't Use The 4% Rule In Retirement

Mar. 17, 2019 1:41 PM ET493 Comments92 Likes
Dale Roberts profile picture
Dale Roberts


  • The 4% or 4.5% rule is a staple rule or thumb for retirement funding.
  • The problem with the 4% rule is that we 'don't spend like that'.
  • Also, it often will not lead to the most tax-efficient model of spending, nor does it allow us to harvest our retirement assets in the optimal sequence.
  • You might start with the 4% rule as a benchmark, and then throw it out the window of your RV.

Don't get me wrong the 4% rule is a more than useful retirement benchmarking tool. It is used of course to suggest the rate at which you might be able to spend down your portfolio assets in a sustainable fashion.

The rule of thumb suggests that we might be able to spend 4.5% of our portfolio assets, adjusted for inflation each year, with a high probability that the funds could last for decades or even for your lifetime. Of course, there's the risk that the stock and bond markets simply will not to be able to deliver that level of returns.

But this article will focus on the fact that we simply 'don't spend like that'. Very few retirees will spend 4% to 4.5% per year and increase at the rate of inflation each year. We don't spend like that because we don't live like that in retirement. In Retirement Income For Life: Spending More Without Saving More, author Frederick Vettesse looks at the actual spending patterns of retirees. Retirees do not spend in a linear fashion, they spend in waves. As we would expect, we spend more when we are 'younger' and healthy and energetic. We spend less when we lose our health and our energy. We become homebodies. When we lose our health and our energy, we might lose the need to spend at 4.5% or more of portfolio assets.

In retirement, we will typically spend at a more aggressive rate up until the age of 65 and then the spending begins to decrease at a generous rate, and that continues and accelerates. From Retirement Income For Life:

A 2012 EBRI study by Michael Hurd and Susann Rohwedder concluded that real (inflation adjusted) spending by college-educated married couples fell by 1.23 percent a year in their late 60s, 1.75 percent a year in their 70s and 2.75 percent a year in their early 80s.

Further to that…

Another study from the United States, this one by David Blanchett of Morningstar, estimated that real spending declined by about 1% year in the first 10 years of retirement, 2 percent a year in the next 10 years and 1% a year thereafter.

There is a also one-time 30% drop with the death of one spouse.

You might be better off spending down that portfolio in quick order

And never mind the 4% rule, you might embrace a 7% rule or 10% rule. I recently wrote Retirees Might Delay Social Security And Give Themselves A Big Fat Raise. One might be able to create greater and more guaranteed income by first spending down their assets that carry risk (their portfolio) and then moving to more guaranteed pension income. Working in that same guaranteed income space, I recently reviewed Pensionize Your Nest Egg. An annuity offers that same guaranteed fixed income event in that the longer we wait the greater the income that is available. While annuities are not for everyone (I can see most of the self directed investors nodding their head in agreement), they can play a valuable role. They can be a piece of the puzzle. And with the increase of guaranteed income, we might feel more able and comfortable to take on greater risk and a greater growth potential with our personal portfolio.

A retiree might at least cover their basic living needs and perhaps the estimated old age home costs with guaranteed income for life.

And on annuities as a part of the fixed income component, and from my article retirement guru Wade Pfau offers…

Consider an income annuity as part of your overall fixed-income allocation, says Wade Pfau, a professor of retirement income at the American College. “Income annuities are superior to bonds, but not necessarily superior to stocks,” he says.

Mathematically speaking, investors would come out ahead if they replaced their entire fixed-income investment portfolio with income annuities, Pfau says. But this is unrealistic: “It doesn’t account for needing funds for unexpected spending,” he adds.

There you have it from Mr. Pfau, the math says yes to annuities as a consideration.

Healthcare wild cards

A personal healthcare crisis can greatly increase spending needs. Many may not have additional insurance coverage beyond Medicare. These are more than important considerations.

That healthcare wild card is even more of a factor in the US for those early retirees who do not yet have Medicare, and may not have sufficient private insurance. And then Medicare also has massive gaps in coverage.

Health insurance and life insurance policies are a staple of personal financial planning for retirees. We also need to cover ourselves with a generous emergency fund that is liquid and usually in a high interest savings account. Many will use a personal line of credit as a significant portion of that emergency fund.

Our inflation rate in retirement does not mirror the CPI inflation rate

In retirement, your personal inflation rate will likely not mirror that of the accepted inflation measurement benchmarks. And then the government agencies take over and they dictate how much we must remove from our registered retirement portfolios with mandated withdrawals. Sure, we don't have to spend those monies, but those required minimums will certainly affect our tax rates and overall spend rates. Taxes and fees need to be taken into consideration when estimating spend rates.

Our spending patterns are dynamic in retirement

Our spending needs and wants are dynamic, we should be prepared to adjust and change our spend rates. I think we should also be open to what might be a non-traditional order of harvesting our retirement assets. The math might say spend down your personal portfolio first. Every retiree has a unique and optimal spending pattern or sequence for harvesting their assets.

Most of us will be best served to contact a trusted professional to discover how to optimize retirement funding. Estate planning and the desire to leave a financial legacy adds additional complexities. This level of financial planning is outside the scope of a self-directed investor.

You can use a fee-for-service advisor and then self direct your portfolio assets to keep fees low. Most of us certainly do not want to hand over a portion of our assets in fees on a daily basis.

How is the 4% rule useful?

The 4% rule might show us how aggressively we might be able to spend when we need to squeeze every penny out of the portfolio in a sustainable fashion. That said, we might also be prepared to spend more or less based on market conditions. The 4% rule also helps us estimate how much we might need to retire - estimate that 'magic number'.

And then, we'll have to be prepared to bend that rule of thumb.

Author's note: Thanks for reading. Please always know and invest within your risk tolerance level. Always know all tax implications and consequences. If you liked this article, please hit that "Like" button. Hit "Follow" to receive notices of future articles.

This article was written by

Dale Roberts profile picture
Dale Roberts is the Chief Disruptor at the Cut The Crap Investing blog. Cut The Crap will introduce Canadians to the many sensible low fee investment options in Canada. Canadians currently pay some of highest investment fees in the world. Dale will help Canadians on the path to creating their own low fee portfolios or direct them to the lower fee managed portfolio solutions. Dale was a former Investment Funds Advisor and Trainer at Tangerine Investments, and is a still recovering former award-winning advertising writer and creative director. Dale has been writing on Seeking Alpha from 2013, covering asset allocation, dividend investing and retirement. As always past performance is not guaranteed to repeat. You should always conduct your own research or speak to a financial advisor. If you don't know what you're doing, don't do it. Dale's articles are not investment advice.

Disclosure: I am/we are long BNS, TD, RY, AAPL, BCE, TU, ENB, TRP, CVS, WBA, MSFT, MMM, CL, JNJ, QCOM, MDT, BRK.B, ABT, BLK, WMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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