One of the most important and difficult questions to answer in retirement is how much you can spend each year without going broke. The most popular answer to this question is what is known as the 4% rule. From a 1994 paper written by Certified Financial Planner Bill Bengan, here’s how it works.
In the first year of retirement, you can spend 4% of your savings. This 4% is known as the Safe Withdrawal Rate. Each year thereafter you can adjust your spending by the rate of inflation. According to Mr. Bengen’s research, if you follow this strategy, your money should last at least 30 years in retirement.
The 4% rule is simple, easy to follow, and totally misunderstood. Here are four things about the 4% rule that almost nobody understands.
1. It’s Just One of a Thousand Possible Answers
The conclusion that Mr. Bengan reached in his 1994 paper rests on a number of critical assumptions. For example, he assumed a 30-year retirement, a portfolio that consisted of the equivalent of an S&P 500 Index fund and intermediate term treasury bonds, and that spending would go up each year by the rate of inflation as measured by the CPI.
In truth, he made many other assumptions, some of them not explicitly stated, such as the following:
- That a retiree retired on January 1;
- That the retiree paid no investment fees;
- That the retiree rebalanced their portfolio once each year; and
- That the strategy must succeed 100% of the time based on historical data;
If we change any of these assumptions, the 4% rule turns into something else. in some cases it’s just a minor adjustment, perhaps becoming the 4.1 or 3.9% rule. Even changing when one retires during a given year can change the results, as Mr. Bengen himself noted in a subsequent paper.
The point is that the 4% Rule is just one result from what could be thousands of different results based on changes to these assumptions. In fact, today Mr. Bengen believes that the Safe Withdrawal Rate is actually 4.7% based on using different asset classes for stocks.
2. It Assumes a 100% Success Rate
As noted above, Mr. Bengen’s paper demanded a 100% success rate. He looked at 51 different 30-year retirements and concluded that using 4% as the initial safe withdrawal rate succeeded in all of these periods dating back to 1926.
A 100% success rate seems like a safe approach. After all, retirees’ biggest fear is running out of money during retirement. Yet when it comes to modeling withdrawal strategies using Monte Carlo simulations, nobody demands of 100% success rate. The thing to recognize is that demanding a 100% success rate comes at significant costs.
In the case of the 4% rule, the vast majority of the time dating back to 1871, a retiree could have started with a much higher initial spending rate. In fact, using just 4%, many retirees after 30 years have as much as six times the amount of money they started with. That’s a lot of money to leave on the table during your golden years.
Using one of my favorite retirement tools, FICalc, and assuming a 75% stock and 25% bond portfolio, one could start with a 4.9% initial withdrawal rate and have an 80% chance of success over a 30-year period. Of course, during that time if things started to look bleak, one could cut back their spending.
3. You Don’t Need a Safe Withdrawal Rate At All
Another misconception is that a retiree needs to figure out an initial safe withdrawal rate. Countless papers have been written critiquing the 4% rule. Some say it’s too high, particularly if you factor in current valuations and yields. Others say it could be higher if you implement what are called guardrails. With guardrails, a retiree can increase or decrease their spending based on how market returns and inflation turn out.
But what many don’t understand is that there are spending strategies in retirement that don’t require an initial safe withdrawal rate at all. For example, the Spend Safely in Retirement Strategy is based on delaying Social Security and using the required minimum distribution formula for calculating your yearly spending. Unlike the 4% Rule, this approach is based on your age and balance of your investments. In this regard, it’s a much easier method to follow at least psychologically. One wonders how many retirees cut back their spending in 2022 when inflation spiked and the market fell.
4. Nobody Actually Uses The 4% Rule In Retirement
Finally, almost nobody actually uses the 4% Rule in retirement. True, this observation is based on anecdotal evidence. I’ve run a YouTube channel about investing and retirement for the past several years. During that time I received tens of thousands of comments and emails from viewers. I’ve yet to meet someone who is using the 4% rule in retirement.
There are at least two reasons for this in my view. First, retirees don’t spend the same of money after inflation each year in retirement. In fact, studies show that retirees tend to spend less as they age, even accounting for medical costs. Second, it is very difficult to follow the 4% Rule during a bear market. The reality is that most retirees cut back when the market falls.
In fairness, I have met one person who tells me that he follow sthe 4% rule. Mr. Bengan himself. I interviewed him on my YouTube channel, which you can check out here.