Despite its obvious flaws, the 4% Rule of thumb for determining “safe” withdrawals from invested assets retains its popularity among many personal financial journalists, financial advisers, academics and bloggers. While experts acknowledge that the 4% Rule may have certain weaknesses, they claim that these flaws can be addressed with specific modifications. We at How Much Can I Afford to Spend have never been big fans of the 4% Rule, with or without proposed modifications, and we believe the Actuarial Approach is a far more robust approach for budgeting and personal retirement financial planning. Some of our posts on the 4% Rule include (in chronological order):
- October 9, 2014—20 Years of Drinking the 4% Rule Kool Aid
- June 24, 2015—Will “Ratcheting” the 4% Rule Make it Less Insane
- May 9, 2016 and June 3, 2016—Adjust the 4% Rule Enough and You Might End Up with Something as Good as the Actuarial Approach, Parts 1 and 2
- July 23, 2019—The Real Problems with Using the 4% Rule to FIRE
- June 14, 2020—Focus on Retirement Spending, Not Retirement Income
The June 14, 2020 post highlights the many shortcomings of the 4% Rule and Strategic Withdrawal Strategies in general.
In this post, we will briefly discuss the common understanding of today’s “static” 4% Rule of thumb and compare it with the more “dynamic” versions anticipated by the authors of the research that produced it. We believe the original 4% Rule researchers did not necessarily believe that the rule should be strictly applied on the static set-and-forget strategy into which this popular rule of thumb has evolved, but should instead be a part of a more dynamic planning process (like the Actuarial Approach).
The Static 4% Rule
The 4% Rule is commonly interpreted today as implying that if an individual invests at least 50% of his or her portfolio assets in equities and the remainder in corporate bonds, such individual can safely withdraw 4% of the portfolio value during the first year of retirement and increase subsequent annual withdrawals by the increase in inflation without depleting the portfolio prior to the retiree’s demise.
When planning when to retire under this rule of thumb, the individual should plan on accumulating 25 times (1/.04) the expenses expected to funded by the portfolio.
The implied plan under this common “set and forget” interpretation of the rule is to stay the course and increase annual withdrawals by inflation, irrespective of actual favorable or unfavorable investment performance.
Recent Interview with William Bengen
In a recent post, Michael Kitces interviewed William Bengen, “the father of the 4% Rule”, and also a financial advisor. Key takeaways from the interview that support Bengen’s intent to apply a more dynamic 4% Rule include:
Bengen’s plans for clients were not set and forget strategies
“So I just basically reviewed with my clients every year indicated…I compared the balance that they had in their account with the balance we thought they should have based on the 4.5% rule.”
Bengen didn’t use Monte Carlo modeling
“I didn’t use it a lot… I’ve pretty much stuck to the spreadsheet approach. “
He called the rule a “guide”.
“You have to be very upfront with clients and explain to them that this is not a science we’re doing. Okay? It’s not like Isaac Newton sitting down and developing his three laws of motion in physics, which will probably stand for billions of years into the future. What we’re doing is almost a social science. We’re examining the past and we have data, but we don’t have an underlying theory that relates data and facts. So we can’t use it to predict anything. We can only use it as a guide.”
He developed different withdrawal rates for different clients depending on their situation
“I use about a 4.2% number to start. But you know every client’s situation is different. I had clients that were 5.5% because they are expecting a large inheritance, let’s say five years down the road, that they’re fairly certain of. And I have clients who were down at 3% because they had a pension plan that had no inflation adjustment. So over time, they were going to have appreciating demands put on their portfolio to support their income stream. So, yeah, we start with four, but there’s a wide spectrum around it.”
He didn’t stick to the 50% investment in equities requirement
“I remember my wife’s brother, who lived in Alabama, passed away in September 2008. And before I left the office, I had clients essentially down to zero stock allocation, maybe a couple percent. And then, in Alabama, I sold what was left.
Eventually, of course, the money came back, or a lot of it. Thanks to QE. But I didn’t have the process in place at that time to get back into the market. There were clear indications now, if you look at that March and April we should be heading back in there heavily.
So preserving capital has always been important to me. So I just thought the risk was so great at that point. I said let’s get out and sit and wait and see what happens and how they resolve this. And I have seen every weekend that they were working to patch up another leak in the system.”
The Trinity Study
In 1998, three finance professors at Trinity University released their research which expanded the research performed by Mr. Bengen. This research became known as the Trinity Study.
The results presented in the second column of Table 3 of the Trinity Study form the basis of today’s static 4% Rule. This column shows that based on actual experience from 1926-1995, a hypothetical individual who invested at least 50% of his or her portfolio in equities and the remainder in corporate bonds had a 95% or greater probability of not running out of money for 30 years if he or she withdrew 4% of the initial portfolio value and increased that initial withdrawal amount annually by the increase in the Consumer Price Index (cpi).
Individuals with lifetime planning periods less than 30 years or who did not increase their withdrawals with inflation could justify increasing their “safe” withdrawal rates based on the Trinity Study results.
While the initial period from 1926 to 1995 used by both Mr. Bengen and the Trinity professors has been updated to reflect more recent stock and bond experience, and results for the entire updated period still appear to support the Trinity Study conclusions, it is important to note that historical experience may not be a good predictor of future experience. Readers may find Dr. Wade Pfau’s analysis of the 4% Rule with updated Trinity Study data to be of interest.
Also, in a more recent April 14, 2020 ThinkAdvisor article, when asked if the 4% rule of thumb still apply when it comes to income planning, Dr. Pfau said,
“No. The probability that it would work is a lot lower now. It worked in the U.S. historically, but [previous years] never dealt with low interest rates and high stock market valuations at the same time.”
It should also be noted that the Trinity Study authors didn’t necessarily imply that the 4% Rule was the “set and forget” static strategy that many current financial experts now claim. Instead, they said,
“Mid-course corrections likely will be required, with the actual dollar amounts withdrawn adjusted downward or upward relative to the plan. The investor needs to keep in mind that selection of a withdrawal rate is not a matter of contract but rather a matter of planning.”
And, while the Trinity authors indicated that mid-course corrections would likely be required, their research didn’t discuss when or how an individual’s plan should make such corrections.
Summary
Over
the past 20+ years since release of the research by Mr. Bengen and the
Trinity College finance professors, the 4% Rule has evolved from a
flexible planning guide into more of a static set-and-forget rule.
Rightly or wrongly, it has unfortunately attained a near cult status as the
safe rate of withdrawal from portfolios of invested assets. We aren’t
going to repeat in this post all the problems we see with this approach
or the modifications suggested by others to deal with these problems.
We simply note that if you adjust the 4% Rule enough to address these
problems, you just might end up with an approach almost as good as the
Actuarial Approach.
