We have never been big fans of the 4% Rule. One of the major reasons we started this blog in 2009 was because we didn’t particularly care for the 4% Rule, and we thought we could help people make better financial decisions by suggesting a more dynamic (flexible) spending strategy based on fundamental actuarial principles. In 2014 alone, we posted four separate posts trying to convince our readers to ditch the static 4% Rule and adopt the dynamic Actuarial Approach that we recommend.
The title for this post is a slight modification of the title of a recent article by the well-respected researcher Dr. Michael Finke (by expanding the question to include DIY Retirees) that we will discuss in this post. His Think Advisor article is entitled, “The 4% Rule Is Dead. What's an Advisor to Do?”
Despite the demise of the 4% Rule implied in Dr. Finke’s article title, we believe that the 4% Rule, and its many iterations and “safe withdrawal rate” cousins, are, unfortunately, not dead. The rule is just too popular with retirees, financial advisors and the financial services media to be killed. Whether this popularity is justified is a separate question.
In this post, we will summarize Dr. Finke’s article after a brief background section.
Background—Recent 4% Rule Research and Discussions
Last November, Morningstar released a research report entitled, “The State of Retirement Income—Safe Withdrawal Rates” in which the authors estimated the safe withdrawal rate for retirees based on the current economic environment to be 3.3% rather than the 4% generally attributed to William P. Bengen based on research summarized in his 1994 paper and commonly known as the 4% Rule. The recent Morningstar research was followed by a flurry of articles, including several by Mr. Bengen himself, discussing various issues related to “safe withdrawal rates” and the 4% Rule, including:
- Is the 4% Rule dead?
- Should the current safe withdrawal rate be below, at or above 4%, and
- How Mr. Bengen’s rule was not really a rule at all, but more of a “finding” based on historical returns
In his Advisor Perspectives article of November 29, 2021, Mr. Bengen notes that safe withdrawal rates are a function of assumed future investment performance. If one assumes current low returns will continue in the future, safe withdrawal rates will be relatively low, and if one assumes they will be higher in the future (and more like historical returns), safe withdrawal rates may be higher. In his article, he explains the difference between his current estimate of 4.7% “safe rate” and the 3.3% figure developed by the Morningstar researchers as follows:
“Who’s correct? The whole issue comes down to whether you accept their forecasts of low returns ‘forever,’ or whether you prefer an approach like mine, which has ‘mean reversion’ built into it. “
As noted above, the 4% Rule is very popular. Unfortunately, we believe a great deal of its popularity stems from the fact that no life annuities (or other protected non-risky income sources) are required to be purchased to fund essential expenses in retirement under the 4% Rule. If one simply assumes future stock and bond returns will be the same or higher than historical returns and one invests approximately 50% of their retirement portfolio in equities, one can “safely” (with apparently very little risk) fund their essential expenses for the expected duration of their retirement. Many financial advisors find this rule (and its cousin the Monte Carlo Model) appealing since advisor compensation is typically based on assets under management (which generally excludes life annuities and lifetime income from pensions). Many individual retirees also like the rule because they believe it can provide greater total spending, more spending flexibility and be just as safe as a comparably-priced life annuity.
So, where does the Morningstar research (which is not necessarily new) and subsequent discussion leave retirees and near retirees (and their financial advisors) as they attempt to plan for retirement? Is the 4% Rule still financially viable, or is it now considered dead to be replaced by a lower “safe” withdrawal rate rule, such as 3.3%? We are going to recommend that you read Dr. Finke’s article for his answer, with which of course, we agree.
Summary of Finke Article
Michael Finke, PhD, is Professor of Wealth Management, Director for the Granum Center for Financial Security, and the Frank M. Engle Distinguished Chair in Economic Security at The American College of Financial Services. He is a nationally renowned researcher with a focus on the value of financial advice, financial planning regulation, investments, and individual investor behavior.
- Finke recommends that instead of using a static spending approach like the 4% Rule, retirees use a dynamic spending approach. According to Dr. Finke:
“Flexible spending, that allows spending a bit higher or lower than a fixed withdrawal rate guideline, seems like a much better approach.”
- Many mass-affluent retired households may benefit from a retirement plan that matches investment risk with the household’s spending flexibility. Thus, these mass-affluent retired households might wish to fund their essential expenses with Social Security, lifetime pension benefits and non-risky investments such as life annuities or dedicated bond funds.
- It is very important to take current low interest rates into account when developing “safe” withdrawal rates strategies. It is inappropriate to simply look at historical experience when projecting future returns.
- Investment risk is real, and retirees must be prepared to reduce spending if they invest in risky assets and “get unlucky.” To hammer home this point, Dr. Finke suggests the following thought exercise:
“An interesting thought exercise may be to ask a financial advisor or their parent firm: “Would you be willing to accept the risk of making income payments adjusted for inflation to any client who outlives their savings?”
This might motivate these advisors and firms to revisit their confidence in the safety of a 4% withdrawal rule. If the advisor assures the client that the rule is perfectly safe, she should be willing to put her own wealth on the line as a backstop.
It is expensive to hedge long-term portfolio and longevity risk, which is why insurance companies charge a fee to provide the protection of a guaranteed minimum lifetime income benefit on a risky portfolio. If asset managers had to provide this same lifetime income protection, they’d charge a fee, too.”
Summary
We
aren’t big fans of static spending approaches like the 4% Rule (or other
“safe” withdrawal rate approaches or even Monte Carlo Model approaches
based on historical returns). We recommend a dynamic actuarial approach
that involves building a Floor Portfolio of non-risky investments to
match household investment risk with household spending (in)flexibility.
Investment in equities (and even some bonds) involves risk. Financial
advisors don’t guarantee investment performance. Guarantees are provided
by insurance companies and they are expensive. Most mass-affluent
retired households that invest in risky assets need to be aware that
such assets may not be available in the future to fund their lifetime
essential expenses, and therefore, such households may want to consider a
safer, albeit more expensive, approach with respect to their essential
expenses.
