For years, we have been told to use the 4% Rule to set our retirement withdrawal targets. We have been told it is the de facto gold standard for computing our retirement needs. What if I told you that the 4% Rule was not adequate for your needs and that there are inherent flaws in the premise that were either wrong or simply out of date? What would you think? What would you do?
Here is how we are taught the 4% Rule was supposed to work:
- Assume the salary you are currently living on is the amount of expenses you will have at age 65 to start your retirement journey.
- Multiply this number by 25 to get the minimum net worth you should have at retirement.
- Deduct 4% in your 1st year of retirement and then in subsequent years deduct this dollar amount + inflation rate to have a comfortable 25-30 year retirement.
For example, assume your current salary is $100,000. Multiplying this number by 25 means you should have saved at least $2.5M by age 65. At age 65, you can safely deduct 4% in your 1st year of retirement ($100,000) and then in year 2 you can deduct $100,000 plus the current year’s inflation rate (for our purpose, let’s assume the historical inflation rate of 3.22%), to withdraw $103,220 in year 2. Repeat every year until your retirement years are over.
Theoretically, you should have enough saved up to live a comfortable life and at the end, exhaust the majority if not all, of your savings.
Before we delve into the potential flaws to this theory let’s investigate its origins 1st.
How The 4% Rule Was Originated
The 4% Rule was first introduced by Bill Bengen in the early 1990’s. Bill was a certified financial planner (CFP) from southern California who owned Bengen Financial Services. He wrote a research paper that analyzed and determined a safe withdrawal rate for his clients since no consistent strategies or rules of thumb existed at the time. He not only published his findings in a series of studies in the Journal of Financial Planning but also in a subsequent book. Later, he put his findings into practice with his clients.
He experimented with several different scenarios he felt were worst case and came up with a safe withdrawal rate of approximately 4%.
Over time people have used his research to turn his work into a one-size-fits-all rule of thumb of 4%.
However, as he even admits in an interview he gave for Michael Kitces’s podcast, Financial Advisor Success Podcast, that his work not intended to find a one-size-fits-all number and should not be used in such a way.
What It Doesn’t Take Into Account
Taxes
The 4% Rule was created assuming that a Roth IRA-type investment was being drawn from. As a result, taxes were assumed to be zero.
In reality, withdrawal rates need to take taxes into account when withdrawing from tax-advantage accounts such a traditional 401K’s, Traditional IRA’s. etc. For example, if using the 4% Rule, you intend to withdraw $5,000, after taxes, you will receive more like $3,500 – $4,000.
Financial Services Fees
Another issue I have with the 4% Rule is that fees allocated to financial advisors for managing a portfolio (assuming you have hired a financial advisor) have not been considered. Back in the 1990’s, fee-based services were a new concept and not well received. Most financial advisors at that time charged fees based on a percentage of assets under management (AUM). Bengen’s analysis did not take these fees into account. Even today, many advisors charge fees based on a percentage of assets under management. For example, if you have a $1.25M portfolio and use the 4% rule, $50,000 can be taken out year 1. However, if your financial advisor charges a 1% AUM rate, their annual fee is $12,500. This makes your 4% withdrawal actually costing you 5%.
Various Asset Allocations
The analysis used in the creation of the 4% Rule assumed a 50/50 stock/bond allocation split. From the 1920’s to 1990’s, bonds had a much higher yield. During this time, bonds had a yield from 3-13%. For most of the 1960’s thru 1990’s, the yield was more in the range of 6-13%. Bengen used the late 1960’s timeframe to find his worst-case scenario.
With S&P 500 stock prices mostly in the positive range during this same time period (see graph below from Macrotrends.net), it would have been very safe to assume a 4% withdrawal rate.
Issues potentially arise if a person were to follow the traditional advice of having a bond allocation equal to one’s age. So long as bond prices stayed above the 4% range, it would be safe to assume a 4% withdrawal rate.
Fast forward to current day, while we are in the 11th year of a record bull run, bonds prices have tanked to around 1%. This potentially jeopardizes the use of a 4% withdrawal rate using an allocation strongly favoring bonds. To meet this withdrawal rate, a person’s portfolio would need to be allocated more towards stocks and thereby increasing overall portfolio volatility.
Choosing an appropriate mix of investments is more than a mathematical decision. Picking an allocation you are comfortable with, especially in the event of a bear market or recession not just the one born out of necessity to maintain a lifestyle, is important.
S&P 500 Historical Annual Returns
Assumes historical market returns
Bengen assumed that historical market returns as of 1994 would remain constant in the future. Using historical market returns to calculate a sustainable withdrawal rate could result in a withdrawal rate that is too high.
Using MoneyChimp, the Compound Annual Growth Rate (CAGR) of the S&P 500 from 1920 – 1994 adjusted for inflation and included re-investing dividends (time period Bengen analyzed) was approximately 7.4%.
Looking at the same information from 2000 – 2019, the CAGR is approximately 3.8%.
While I know historical data is all we have to go on and the more data points the better, there is an inherent risk in assuming everything will stay status quo for the foreseeable future.
Given the current low interest rate environment, the high national debt, and the fed’s willingness to use quantitative easing to keep the economy flowing, I think it is safe to bet that the CAGR will stay closer to what we have been seeing in the 21st century vs the 20th century.
Here’s why I think this might happen: The current federal debt is at approximately $27T and climbing. To offset the interest owed on the national debt, the government has been using quantitative easing to keep the economy going and force interest rates to reman low. The reason the government needs low interest rate is to offset the interest payments they are expecting on the national debt. As shown below, interest payments on the national debt are projected to grow more quickly than any other part of the national budget, including Medicaid and national defense. At its current debt growth rate, by approximately 2028 the interest payment will be approaching $1 trillion dollars annually!
One way to combat this is to keep rates low. Good for debt payments but bad for investing. If interest rates were to increase even to historical levels, the cost of servicing the national debt increases significantly.
Inflation
Inflation can really impact a person’s retirement even more so than a bear market. The reason for this is that eventually a bear market ends, and the market starts to recover. However, higher prices rarely if ever go back where they were before and get locked in.
The worst-case assumption for your portfolio should include a high inflation rate such as what we saw in the 70’s.
As shown in the chart below, we have been very fortunate to be living in a low inflation environment for over the last 20 years. The Feds have been trying for years to keep inflation at around 2% on an annual basis. However, that is soon to change.
Recent changes by the Federal Reserve’s policy to allow more average inflation targeting can potentially raise inflation rates. Inflation targeting means that the Fed will allow inflation to increase above 2% for an unspecified period so long as the overall average over the same period is around 2%.
I don’t know about you but to me, this appears to me like the Federal Reserve is trying to force higher inflation fluctuations and it puzzles me as to why. Keep your eyes focused over the next few months on what the Federal Reserve is doing. It might be worth it to publish article on this site! 😊
Also shown in the chart below from macrotrends.net, the reality is if your retirement is 20 years away or more, there is a strong probability that high inflation will come back at some time during your retirement years. It’s better to assume now and plan for it than not.
Historical Inflation Rate by Year Since 1914
Rigidity
The 4% Rule assumes a constant spending rate and doesn’t take life’s spending fluctuations into account. What about the occasional big purchase? Buying a new car to replace the raggedy old one, helping family members, or the occasional expensive vacation trip that was on your bucket list do not appear to be taken into consideration.
What about the flipside with expenses that were not originally considered when planning for retirement such as unexpected medical expenses or living in a retirement home. The average person aged 65 can expect to pay, on average, approximately $295,000 in medical expenses during retirement. The national average cost for living in a retirement home is approximately $4,000 / month but can cost from $2,900 – 9,200 per month depending on the state you live in.
Also, the 4% Rule does not consider portfolio performance. It assumes you keep a 4% withdrawal rate no matter what condition occurs. Eating into the principle of your portfolio compounded with other factors like inflation is a surefire way to outlive your retirement funds. Nothing would stink worse than potentially eating bologna and potato chip sandwiches to get by in your later years.
Finally, the 4% rule does not take required minimum distribution (RMD’s) into account. RMD’s are required once a person reaches the age of 72. How much that must be withdrawn each year is decided by a formula. For example, let’s assume for the sake of argument, we need to calculate the RMD of a person age 72 with a $1M portfolio. Using the RMD calculator from IRS.gov, the withdrawal factor is 25.6. Dividing $1M by the withdrawal factor yields an RMD of $39,062. At age 73, the withdrawal factor is 24.7 and yields an RMD of $40,486.
As you can see, the older you get, the more the government requires a person to withdraw from their retirement accounts. Letting your account accumulate as much as possible before making these RMD’s can really help you in the long run.
Retirement Years Have Changed
When Bengen did his research, the average person’s retirement spanned between 25-30 years. He used the 4% Rule using a 30 -year retirement span since this was worst case. Today, this is not necessarily the case.
Between longer life expectancy and people looking to retire earlier, the average retirement can easily span 35 years or more. Also, there is a high probability that, if married, at least 1 of the couple will live to at least the age of 95.
People used a 25X ratio to roughly estimate how much money they need to retire on. This made sense since the retirement duration was roughly 25 years. Given the potentially longer retirements, a person may want to think about modifying not only the 4% Rule but other rules of thumb as well.
Lack of Pensions to Supplement Income
When Bengen did his analysis back in the early 90’s, 42% of people in the U.S. had a defined benefit pension plan. Today, that number has shrunk to under 13%.
In the past, people used their pensions to pay for their living expenses and then used 401K’s / IRA’s to supplement their pension for both “fun” as well as unexpected expenses. Today, most people now solely rely on 401K’s / IRA’s to fund their entire retirement.
The sad and unfortunate fact is that the 401K was never designed or intended to be the sole funding vehicle for retirement. As we discussed previously, the traditional stock / bond only portfolio introduces a lot of potential risk and volatility if entirely relied on. If using the 4% Rule, there is additional risk that too much money could be withdrawn and eat into the principle. This could exacerbate a situation if also occurring during a market downturn.
What You Can Do Instead
Create Your Own Rule
People need to look at their situation as unique and plan accordingly. I am a big fan of making a retirement budget and developing a worst-case situation. Assuming the historical inflation rate of 3.22% and the Rule of 72, expect prices to double roughly every 22 years (72/3.22 = 22.36). Use this to develop a budget that includes quality of life expected, hobbies, travel, medical expenses, living in a retirement home, whether an inheritance will be left, etc.
If looking for a rough estimate, use a variation of the 4% Rule as a guideline only. Plan for at least a 35 Year retirement. Using the 4% Rule as a starting point, try the following:
- Start with a 2.85% withdrawal rate BEFORE taxes (100/35 years – 2.85%)
- Deduct taxes assuming 25% tax rate based on the 2020 tax bracket guidelines
- NOTE: This assumes a traditional 401K and/or IRA. A Roth 401K and/or IRA is withdrawn tax free and this step can be skipped.
- Add in a margin of safety. For this discussion, let’s use 20%.
- Calculation is: 2.85%*(1-0.25)*(1-0.20) = 1.71% withdrawal rate
I know this may seem like an extremely conservative estimate but when it is your life at stake, I’d rather be realistic and conservative than overly optimistic.
Create Your Own Pension
Having a realistic budget that has your known worst-case expenses and your “fun” expenses has other benefits. Another way to hedge your retirement is to create your own pension. Life insurance companies sell a plethora of annuities and whole/universal life policies that, if designed correctly, can act like a pension and provide a steady income stream throughout your retirement while leaving an inheritance to your family.
Another way to hedge retirement is to investigate alternative income streams to generate steady cashflow in retirement. Rental properties, REIT’s dividends payout, and owning a business are all other ways a person can create a “pension” to cover basic living expenses in retirement.
In Closing
Remember the 4% Rule is NOT a law of nature, it is empirical. It was intended to be used as a guideline not an absolute occurrence so use it as such. Keep in mind that unexpected things will come up and build it into your plan. Options exist and it is to your benefit to look at all the tools in your toolbox to make your later years as enjoyable and stress-free as possible. It is WAY better to have money leftover after your retirement is done than it is to outlive your funds. Be proactive and make it happen. You’ll be glad you did! 
Live the Life You Love, Want, and Deserve……