Thursday, October 9, 2014

20 Years of Drinking the "4% Rule" Kool-Aid

This month's Journal of Financial Planning celebrates the twentieth anniversary of publication of the article, "Determining Withdrawal Rates Using Historical Data", by William P. Bengen.  This article formed the basis for what is now known as the "4% Rule" or "4% Withdrawal Rule."

In this month's Journal article, Jonathan Guyton, CFP, offers his thoughts on the original research performed by Mr. Bengen, and Mr. Guyton's article contains glowing praise from many others for Mr. Bengen's research.  According to Mr. Guyton, "Bill Bengen framed a deceptively complex question and crafted and elegant simple answer that remains relevant two decades later for hundreds of thousands of financial advisers and easily 100 million retirees."

As someone who doesn't understand the appeal of the 4% Rule, or it's many safe withdrawal rate progeny, please forgive me if I don't enthusiastically join in this celebration.

Based on historical returns provided by Ibbotson Associates' Stocks, Bonds, Bills and Inflation 1992 Yearbook, Mr. Bengen noted that hypothetical individuals who retired in each year from 1926 to 1976 who invested at least 50% of their assets in equities and who withdrew 4% of accumulated assets in the first year of retirement and increased that amount by inflation each year would be expected to have their assets last at least 30 years (Figure 1b of Mr. Bengen's article).  As a result of this analysis of these historical returns, Mr. Bengen concluded that it was "safe" going forward for almost all retirees to withdraw 4% of accumulated assets in the first year of retirement and increase that first year amount by inflation for subsequent years if they invested at least 50% of their assets in equities and rebalance their portfolio each year.  In fact, Mr. Bengen said, "It is appropriate to advise the client to accept a stock allocation as close to 75 percent as possible and in no cases less than 50 percent."

I agree with the concerns expressed about the 4% Rule expressed by researcher Nobel Laureate, William Sharpe in his article, "Staying Flexible on Retirement Spending" (highlighted in my second post in 2010) where he points out the problems inherent in combining a fixed spending strategy with investment of a portfolio with variable returns. 

I list what I believe to be the many shortfalls of the 4% Rule in this website and in my recently published article in the Journal of Personal Finance.  For brevity sake, I will not be re listing them here.  Suffice to say that the 4% Rule requires the retiree to have faith that historical performance is a good indicator of future experience and the retiree should "stay the course" irrespective of actual investment returns or spending. By comparison, the Actuarial Approach advocated in this website suggests looking to see whether the retiree is "on track" on an annual basis and making appropriate adjustments.  

In the twenty years following release of Mr. Bengen's original research, many researchers have suggested modifications to the 4% Rule to deal with its significant shortcomings and to refine the assumptions and methodology (Monte Carlo modeling) used to forecast future experience.  In fact, an example of such refinement is also featured in this month's Journal of Financial Planning entitled, Retirement Planning by Targeting Safe Withdrawal Rates, by David Zolt, CFP, EA, ASA, MAAA.  This is an update of Mr. Zolt's original article which I discussed in my post of May 23rd of last year.  Like many suggested modifications to Mr. Bengen's original work, Mr. Zolt has dealt with some of the problems, but his approach and various tables are much more complicated than Mr. Bengen's "elegant simple answer."  I will be discussing Mr. Zolt's approach in a subsequent post.

Bottom line:  Retirees who invest in risky assets should not expect those assets to produce a fixed level of real income in retirement as implied by the 4% Rule or other safe withdrawal rate approaches.  They need to use a dynamic withdrawal approach (like the Actuarial Approach advocated in this website) and live with the fact that that sometimes their spending budget may increase or decrease in real terms from year to year, depending on actual investment experience and spending.