Is the 4% Rule Useful or Bull$hit?
Examining the most popular rule of thumb in retirement planning
As a rule of thumb, you should never live your life based on rules of thumb.
In this edition of Calling Financial Bull$hit, I look at the most influential rule of thumb in retirement planning; the 4% rule, and decide whether the 4% rule is worthy of its popularity or if it’s Bull$hit.
What is the 4% rule?
Rules of thumb can be effective educational tools. They help take a complex problem — like how to live off your savings for 30 years — and boil it down into a straightforward concept.
To help people with the complex problem of living the lifestyle they want in retirement without running out of money, we have the 4% rule.
According to the 4% rule, you could withdraw 4% of your retirement savings to pay for your cost of living in retirement. If you had $1 million saved, you would withdraw $40,000 in year one of retirement and then increase that by the level of inflation each year.
The origins of the 4% rule can be traced back to a 1994 paper in the Journal of Financial Planning by William Bengen.1
In his study, Bengen used U.S. data and built a hypothetical portfolio of 50% stocks-50% bonds to find the highest sustainable withdrawal rate for a 30-year retirement.
To do this, Bengen modeled the returns of this portfolio for every 30 years from 1926 to 1992. He found a 4% withdrawal rate was the maximum safe withdrawal rate for a 30-year retirement.
In 1998, a second study known as “the trinity study” (named after Trinity University, where the study was done) found similar results as Bengen.2
The Trinity study found that a 4% withdrawal allowed retirees a 95% chance of not running out of money.
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The 4% Rule: At What Price?
A paper published in the Journal of Investment Management in 2008 explores the inefficiencies of the 4% rule.3
This quote from the paper describes the central inefficiencies of the 4% rule:
“Fixed spending is best supported by fixed payouts—volatile payouts lead to surpluses and deficits.”
The 4% rule only works if a large portion of your retirement spending comes from the stock market, which has volatile payouts. With the 4% rule, you can die with a huge surplus or run out of money years before you die.
While most people would prefer dying with a lot of money in the bank—especially if leaving an inheritance is important—it is inefficient. I am reminded of a quote from the 1938 film You Can’t Take It With you:
Maybe it'd stop you trying to be so desperate about making more money than you can ever use? You can't take it with you, Mr. Kirby. So what good is it? As near as I can see, the only thing you can take with you is the love of your friends.
Dying with a few million in the bank means you leave this world with a lot of missed opportunities. You could have spent less of your life working and spent more of your money on experiences with your friends and family.
Running out of money years before your death is a nightmare. You become financially dependent on those closest to you. Even if they are willing to help—there can be no doubt that it puts a strain and often creates real hardship for the people you care about most.
Both scenarios are on the table if you follow the 4% rule and have your retirement spending dictated by market outcomes.
The author argues that fixed expenses—such as rent, utilities, and transportation—should be paid for with fixed income. They do not go to the next step and describe those fixed-income instruments, but two popular fixed-income sources for retirees are bonds and annuities.
You probably know what bonds are—if you don’t pick up a copy of The Rational Investor—but you may be less familiar with annuities.
An annuity is a contract between you and an insurance company in which you make a lump-sum payment in exchange for a series of guaranteed monthly payments.
(General Warning: Annuities are complex beasts, and there are bad actors in the financial services industry that sell crappy, high-fee annuities because it pays a hefty commission. Anyone thinking of buying an annuity should seek the advice of a fiduciary financial advisor.)
Annuities are largely ignored by the general public — and most people who know what an annuity is don’t like them. So naturally, economists love annuities.
Economists love annuities because economists want to minimize the risk of a retirement plan failing. Guaranteed income can help minimize sequence of return and longevity risks. If an annuity increases with inflation, all the better.
A lifetime inflation-adjusted annuity that covers your basic living expenses is an extremely rational approach to retirement.
If you know that all of your basic needs will be taken care of, you have the security and confidence to manage the remainder of your portfolio like a long-term rational investor.
The retirement spending smile
Another central feature of the 4% rule is that it provides consistent real spending each year in retirement. If you retire with $1 million, the 4% rule would have you spend $40,000 per year—adjusted for inflation—each year of your retirement.
It’s easy to think about retirement spending in fixed terms. In reality, your retirement spending will change drastically in three separate phases.
Early retirement: Spending is high as you engage in more travel and time with grandkids.
Mid retirement: Where spending drops dramatically as you slow down and travel and spend less.
Your final years: Where healthcare costs begin to mount, and your spending increases dramatically.
In a 2014 paper, David Blanchett refers to this as the “retirement spending smile,” where retirement spending starts high, quickly falls, and then increases as your health fails and healthcare costs pile up.4
The big wildcard in The Retirement Smile is healthcare costs. Blanchett’s research uses U.S. data where healthcare costs are paid for largely by individuals. If you live in a country where the public/government pays for healthcare, you may not have the same level of late-year retirement spending. In that case, your retirement spending smile may look more like a retirement spending ski hill where you start with high spending, and spending begins to decline year-over-year.
Either way, your retirement spending is not constant.
This lends credibility to the idea of covering your fixed expenses with fixed income and allowing your variable spending, which will be volatile during retirement—like travel—to come from a more volatile source, like market returns.
The fine print of the 4% rule
Like any rule of thumb, the 4% rule oversimplifies a complex issue and fails to address many of the very real problems. Here are a few of the assumptions and limitations of the 4% rule.
It’s not a flexible plan. The 4% rule advocates you increase your spending each year by the rate of inflation regardless of what is happening in the economy or financial markets. It fails to deal with questions like, what if inflation is 8%? What if the market goes down 50%?
It’s modeled using a 50/50 portfolio of U.S. stocks and bonds. That is a very specific asset allocation that does not include global diversification.
It relies on historical U.S. market returns. Past returns do not imply future returns. At the time I write this, interest rates are historically low, which means expected future stock and bond returns are lower than in the past.
It assumes a 30-year retirement. The 4% rule fails to answer questions like what happens if you retire at 65 and live to be 110?
It ignores taxes and investment fees. This is a perfect example of how a plan can look better in a spreadsheet than in real life.
This highlights the limitations of financial rules of thumb, like the 4% rule. It’s a helpful way to ease your way into the topic of withdrawal rates in retirement, but it should be the beginning, not the end, of your research into this topic.
The only evidence you need to illustrate the limitations of the 4% rule is that its creator does not follow the 4% rule in his own retirement plan.5
Final verdict
After reviewing the evidence, it’s a split decision:
The 4% rule serves a useful but very specific purpose: It’s a simple way to learn about the concepts of safe withdrawal rates and begin thinking of your retirement saving as a vehicle for funding your spending in retirement.
But, as an actual rule to Follow in Real life? It’s Bull$hit.
You can read more entries in The Calling Financial Bull$hit series here.
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Bengen, W. (n.d.). ETERMINING WITHDRAWAL RATES USING HISTORICAL DATA. https://www.retailinvestor.org/pdf/Bengen1.pdf
https://www.aaii.com/files/pdf/6794_retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable.pdf. (n.d.). Www.aaii.com. https://www.aaii.com/files/pdf/6794_retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable.pdf
Scott, J. S., Sharpe, W. F., & Watson, J. G. (2008, April 1). The 4% Rule - At What Price? Papers.ssrn.com. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1115023
Exploring the Retirement Consumption Puzzle. (n.d.). Financial Planning Association. Retrieved February 28, 2023, from https://www.financialplanningassociation.org/article/journal/MAY14-exploring-retirement-consumption-puzzle
Opinion | Not So Easy to Follow the 4% Rule in Retirement. (2022, April 26). Wall Street Journal. https://www.wsj.com/articles/retirement-planning-four-percent-rule-bengen-investment-11650923000