Why The 4% Withdraw Rule is Wrong

Imagine retiring with peace of mind, confident that your savings will last. The 4% withdrawal rate rule promises just that. But is it foolproof?

Once you begin to think about retirement, you will stumble upon the 4% withdrawal rate rule. Simply put, it states that if you only withdraw 4% per year in retirement from your retirement accounts, then you will not outlive your assets.

This may be a good place to start when thinking about retirement funds, but the 4% rule leaves a lot to be desired. Like most rules, it has become too simple and too general to be completely effective. Following the rule blindly can leave you living with regret. Taking too much out of your retirement portfolio can cause you to run out of money, but taking too little out of your portfolio can cause you to live with a lower standard of living.

The Origin and Methodology Behind the 4% Rule

In 1994, William Bengen developed the 4% withdrawal rule. As a financial adviser, he was fascinated with the markets and was able to answer the question, “How much money should I have for retirement?” Thanks to computers and spreadsheet software, Bengen figured he could run tests to see exactly how much money a person could safely withdraw from their portfolio and not outlive their assets.

He used historical market data on stocks and bonds over a 50-year period, from 1926-1976. This period was enough to include severe market downturns in the 1930s and the 1970s. He was able to construct rolling 30-year periods that were made to simulate the 30 years of retirement. He started with the period of 1926-1955, and then moved to 1927-1956, and so-on. For each period, he calculated the maximum sustainable withdrawal rate. That is the maximum amount that a person can take out of their portfolio and still have enough assets to last their entire retirement. He finally concluded that there was no historical case where a 4% withdrawal rate from your portfolio would exhaust your assets in less than 33 years; this was his worst-case scenario. This 4% withdrawal rate became his SAFEMAX number and has redefined retirement planning ever since.

To achieve these results, Bengen recommended a stock allocation of no less than 50% and as close to 75% as you are comfortable with. Running several tests on different stock to bond asset allocations, Bengen found that an all-bond portfolio would drop the SAFEMAX to 2.5%. With an asset allocation between 35% and 80%, the SAFEMAX hovered around the 4% level.

In a newer study, he modified the withdrawal rate to 4.5%. By mixing different types of assets into your portfolio, such as small or micro-cap stocks, you could increase the withdrawal rate because it would increase the overall returns. Even though these studies have come out, the 4% rule has always stuck.

The 4% rule is great because it will be hard for the stock market to break it. It is conservative enough that the dips and declines of the market have yet to set a new and lower withdrawal rate. The rate was set considering the Great Depression and the stagflation of the 1970s. When re-tested on the technology bubble of 2000 or the Great Recession of 2008, we see that the 4% rule holds up every time. There may be a period when the 4% rule will be broken by the stock market, but it would take a large decline and a very slow recovery period. Even with the 2000’s being considered the “lost decade” for market returns, the 4% rule holds its ground.

While the 4% rule has its merits, it’s essential to consider its limitations.

Why the 4% Rule is Wrong

The biggest issue with any rule is that it becomes too simple. Simple is great, but simple for the sake of being simple is not. Not all cases will be able to follow a general rule, and doing so can leave you with a lot of issues in your retirement.

Retirement is the last of three phases in your life. You have the first thirty-years, which are your pre-working years, the next thirty-years are your income-earning years, and the last thirty-years are your retirement years. Throughout all three of these phases, your wants and needs change. The expenses you have at the age of 30 are not the same you will have at 35 or 45. Your life is dynamic, and your income will need to account for these changes.

Retirement is no different.

The expenses you have at the age of 65 will be vastly different than the ones you have at 75 or 85. There are three phases of retirement: the go-go years, the slow-go years, and the no-go years. Each one of these phases lasts 6-10 years.

The go-go years are the years when you first retire. You are young and want to use this new freedom of retirement to get out and enjoy life. Activities, travel, and new hobbies will pick up during these years. This is the phase of retirement that you will spend the most money in.

The next phase is the slow-go years. You are starting to get older, you’ve done a lot in the last 10 years, and your body is starting to move slower. You will begin to lower the amount of travel you have, the new activities you take on, or the new hobbies you start. You will still do some of these things, but not as much now.

The last phase is the no-go years. You’ve had a great 20 years of retirement living life to the fullest, but now life is beginning to catch up to you. The amount of travel and activities you are doing are beginning to stop altogether. Your expenses are now falling in all areas but medical costs.

As you can tell, your life is going to be dynamic. To think that you will require the same amount of money in your go-go years as your no-go years could leave you extremely short on cash in the years you want to live life. You do not want to get to your no-go years with a large retirement portfolio wishing you traveled more in those first couple of years but couldn’t because you didn’t have the income for it.
Leading financial researcher Michael Kitces concludes, “the nominal wealth path that would have occurred historically for a 60/40 portfolio with a starting balance of $1,000,000 that had a 4% initial withdrawal rate (adjusting spending each subsequent year based on inflation), going all the way back to the 1870s (using Shiller data)…reveal, most of the time, the 4% rule just leaves a large amount of principal behind!”

The next issue with the 4% withdrawal rule is that you need the assets to make the calculation work. What happens if a 4% withdrawal rate is not enough to support your lifestyle because retirement planning came late to you?

Think about how much you spend now on living expenses. Don’t include the liabilities that will fall off, such as a car payment or mortgage payment. For every $40,000 in yearly living expenses, you need $1,000,000 in your portfolio. Are you prepared to drop your living expenses down or delay your retirement to be able to use the 4% withdrawal rule?

Most people would answer ‘no’ to that question. It can be hard to completely reduce your lifestyle to be able to fit into your new spending limits. It can also be equally as hard, or even impossible, to delay your retirement so that you can continue to grow your assets.
Taxable assets also pose another hiccup to the safe 4% rule. Bengen, in his studies, assumed that the money would be coming out of qualified accounts and that the tax impact would be minimal. As your tax rate increases, the SAFEMAX decreases. You must also have a higher stock allocation, closer to 90%, to hit this lower SAFEMAX level.

The 4% rule lends itself to a lack of flexibility. The 4% rule is pretty cut-and-dry, for the most part, stating that you need to take 4% of your money out of retirement accounts to live off of. What happens if you retire at 60 years old but will delay Social Security to 70? Are you supposed to live a reduced lifestyle for 10 years until the extra money from Social Security comes in?

Taking more money out for 10 years until your Social Security kicks in would throw a huge wrench into the system. What happens if those 10 years are during a market downturn, so now you are taking more of your assets out at the beginning of your retirement?
These are all questions that need to be answered and planned for. Unfortunately, the 4% rule will leave you short on answers because it is not meant to plan for this.

Maybe your Social Security and retirement line up perfectly, so this isn’t a worry for you. What happens if you must take out more money this year because of a big purchase, like for that big vacation you wanted to take or the new addition to your home that needs to be planned for? Taking more than 4% out of your portfolio throws the system off.

The Need for Adaptability in Retirement

If you are not going to use the 4% rule for your retirement spending, which method should you take? A lot of consideration needs to go into thinking about the level of your retirement assets and overall retirement goals.

As noted earlier, there will be three stages of your retirement life, and each stage should be planned for accordingly. There are many different systems that could be used, each with its own set of flaws, and none of them will work 100% for everybody that uses them.
Considerations also need to be made for your legacy. What are you looking to leave behind for heirs or charities? Knowing this type of information ahead of time will help set the maximum amount of your assets that you can spend down.

How to Properly Plan for Retirement

Evaluate Your Needs: Before relying on the 4% rule or any other guideline, take a moment to evaluate your individual needs. How much do you spend annually? What are your plans for retirement?
Diversify Investments: While the 4% rule recommends certain stock allocations, remember that diversification can help reduce risk. Consider spreading investments across stocks, bonds, real estate, and other assets.
Stay Updated: The financial market and economy are dynamic. Regularly review and adjust your retirement strategies according to current market conditions.
Seek Professional Advice: Consider working with a financial advisor to create a tailored retirement plan. They can provide insights specific to your situation, such as the right asset allocation, tax implications, and other financial strategies.
Consider Alternative Income Sources: Don’t rely solely on your portfolio. Think about other income streams in retirement like Social Security, part-time work, or rental income.
Plan for Medical Expenses: Health-related costs can be unpredictable. Ensure you have adequate medical insurance and consider setting aside a separate fund for unforeseen medical expenses.
Review Regularly: Periodically reassess your withdrawal rate, especially after major life changes or significant market shifts.
Factor in Inflation: The purchasing power of money decreases over time. Always factor in inflation when calculating how much you’ll need annually in retirement.
Emergency Funds: Keep an emergency fund separate from your retirement savings to cover unexpected costs without affecting your standard of living.
Prioritize Legacy Planning: If you intend to leave behind assets for heirs or charities, plan early. Consider setting up trusts or other financial vehicles to optimize tax benefits and ensure your wishes are fulfilled.
Stay Flexible: Retirement is a phase of life that can span several decades. Your needs and the world around you will change. Be flexible in your strategies and open to adjusting as needed.
Educate Yourself: While it’s beneficial to have professionals guide you, it’s equally important to understand the basics of financial planning. Attend workshops, read books, or take online courses to stay informed.
Avoid Emotional Decisions: The market has its ups and downs. Making decisions based on emotions, especially during downturns, can harm your portfolio. Stick to your plan and consult with your advisor before making changes.
Prepare for All Retirement Phases: As discussed in the article, retirement has different phases. Budget and plan for the active ‘go-go years’ as well as the more sedate ‘no-go years’.

Conclusion

William Bengen gave retirees a way to estimate how much money they would need in retirement. He helped to answer the question, “How much money can I spend and still be okay?” His studies helped change financial and retirement planning by giving people a target and a formula for success.

Unfortunately, his rule has become too simple.

At the very minimum, you could start with the 4% withdrawal rate. This would give you a great base to work from and to improve upon. If you could live off of 4% of your assets comfortably, then you could follow this route knowing that you will be underspending in retirement. It will be better for your retirement to actively plan and manage your retirement assets around your specific situation. By going this route, you can maximize your assets at the proper times in your retirement.

Glossary

4% Withdrawal Rule: A guideline suggesting that retirees can withdraw 4% of their portfolio in the first year of retirement and adjust for inflation thereafter, without running out of money for at least 33 years.
SAFEMAX: The maximum sustainable withdrawal rate from a portfolio, ensuring that assets last throughout the retiree’s lifetime. It’s set by William Bengen at 4% after his extensive research.
Asset Allocation: The strategy of dividing investments among different categories such as stocks, bonds, and cash to optimize returns and reduce risk.
Stocks: Shares of a company’s ownership. They represent a claim on the company’s assets and earnings.
Bonds: Debt instruments that pay periodic interest to holders and return the principal at maturity.
Rolling 30-year periods: A method used to test the sustainability of withdrawal rates by assessing consecutive 30-year windows of time.
Stagflation: An economic condition characterized by stagnant growth, high unemployment, and high inflation.
Go-Go Years: The early phase of retirement where retirees are most active and tend to spend more, especially on activities and travel.
Slow-Go Years: The middle phase of retirement where activity slows down due to age, leading to reduced spending on travel and hobbies.
No-Go Years: The latter phase of retirement characterized by very limited activity and expenditure, primarily on medical care.
Legacy: The assets or wealth one plans to leave behind for heirs or donate to charities after their demise.
Taxable Assets: Investments or properties that generate income which can be taxed.
Qualified Accounts: Tax-advantaged retirement accounts, such as 401(k)s or IRAs, where taxes are often deferred until withdrawal.
Inflation: The rate at which general levels of prices for goods and services rise, leading to falling purchasing power of currency.