The 4% Rule for Retirement: The Trick Is in the Timing

Since at least the Middle Ages, dreamers and schemers have tried to invent a perpetual motion machine – a device that can run forever, with no energy supply. Today, we know better. We may approach the ideal, but thermodynamics informs us that perfection is unattainable. Likewise, those who depend exclusively on the venerable “4% rule” for retirement planning will be disappointed by decades of data that suggests we proceed with caution, especially for those who are planning an extended retirement.

But I get ahead of myself. What is the 4% rule? In what ways can it be useful to your retirement planning, and what are its potential flaws? All good questions for today’s Common Sense Investing video.

A Working Definition of the 4% Rule

The 4% rule for retirement planning suggests that if you spend 4% of your portfolio’s assets in your initial year of retirement, and then adjust for inflation each year going forward, you will be unlikely to run out of money.

To put some inflation-adjusted numbers to it, if you wanted to retire and spend $40,000 per year out of your portfolio, you’d need to have $1 million invested in your “perpetual motion” portfolio for it to supposedly sustain you for the rest of your life without any new capital inflows. You may also see this rule described as having 25 years’ worth of spending power, since 1/25 equals 4%. Same thing.

The Bengen Origins of the 4% Rule

Why 4%, in particular? The number originated in William Bengen’s landmark paper, “Determining Withdrawal Rates Using Historical Data,” published in the October 1994 Journal of Financial Planning.

Bengen was a financial planner who wanted to find a realistic safe withdrawal rate to recommend to his retired clients. His breakthrough in determining a safe withdrawal rate came from modelling spending over 30-year periods in US market history, rather than employing the common practice of using average historical returns. Using data for a hypothetical portfolio split 50/50 between the S&P 500 Index and intermediate-term US government bonds, he looked at rolling 30-year periods between 1926 and 1992. So, the first rolling period was 1926–1955, followed by 1927–1956 etc., ending with 1963–1992.

The maximum safe withdrawal rate in the worst 30-year period ended up being just over 4%. From this innovative analysis, the 4% rule was born. More recently, Bengen adjusted his spending rule to 4.5% based on tilting toward small-cap stocks in the hypothetical historical portfolio.

The 4% Rule in Today’s Markets

While the 4% or 4.5% rule is simple and elegant, it’s probably not the only way to best plan for retirement, especially if you plan on retiring early. After all, without even going into any detailed analysis, think of it this way: If time is a factor in the equation (which it is), it makes sense that no single solution can work for everyone, for all time. Thus, while the rule may be well-founded according to historical US data, there are some caveats to heed, especially when planning for retirement periods longer than 30 years.

In his 2017 book, “How Much Can I Spend in Retirement?” Wade Pfau, PhD, CFA, looked at 30-year safe withdrawal rates in both US and non-US markets using the Dimson-Marsh-Staunton Global Returns Dataset, and assuming a portfolio of 50% stocks/50% bills.

He found only a handful of countries in the entire dataset that would have historically supported something close to the 4% rule: the US at 3.9%, Canada at 4.0%, New Zealand at 3.8%, and Denmark at 3.7%. The aggregate global portfolio of stocks and bills had a much lower 30-year safe withdrawal rate of 3.5%.

Good to know. But, in my opinion, it’s even more important to consider the assumed, 30-year retirement period. People are living longer. Plus, many are choosing to retire earlier. This phenomenon is so popular, there’s an acronym for it: FIRE, or Financial Independence/Retire Early.

And yet I still see bloggers citing the 4% rule for the FIRE brigade. If you’re retiring in your early 60s or younger, how confident are you that 30 years of planning will see you through to the end? If you live significantly longer (and I hope you do), then what???

Some Sobering Statistics

In his study, Bengen showed that the 4% rule with a 50/50 stock/bond portfolio had a 0% chance of failure over 30-year historical periods in the US. But that chance of failure increases to around 15% over 40-year periods, and closer to 30% over 50-year periods.

Let that sink in. Because FIRE likely means preparing for a retirement that could well last longer than 30 years.

Modelling longer time periods using historical sampling becomes problematic because we only have data for a limited number of historical 50-year periods. One way to address this issue is with something known as Monte Carlo simulation. Monte Carlo is a technique where an unlimited number of sample data sets can be simulated to model uncertainty, without relying on actual historical periods.

Even with Monte Carlo simulation, there is an obvious risk to using historical data to build expectations about the future. Some expectations remain more constant, while others are more fluid. Here at PWL Capital, we use a combination of equilibrium cost of capital and current market conditions to build an estimate for expected future returns for use in financial planning, as outlined in our 2016 paper, “Great Expectations.”

So equipped, Monte Carlo simulation helps us reach more realistic numbers for FIRE retirement planning. For example, if a 40-year-old wants to retire today and hopes to live to 95, that’s a 55-year retirement period. Closer analysis suggests their safe withdrawal rate is around 2.2%.

This is such an important message. The 4% rule falls apart over longer retirement periods.

Additional Considerations

We’re just scratching the surface here. There are many other approaches to consider in retirement planning, such as planning to vary your annual spending based on how markets actually perform, minimizing fund fees that can become speed bumps between you and your best outcomes, and considering whether hiring a professional retirement planner may pay for itself through value-added advice.

In my video, I cover each of these points in more detail. Bottom line, while fees are a consideration, they may be worthwhile in exchange for good advice that leaves you feeling more confident about your plans. Of course, if you can attain financial literacy, stay disciplined, keep up-to-date with tax laws and investment products, and maintain your cognitive abilities into old age, you may be able to make your own good financial decisions without paying a fee for advice.

Have you ever thought about applying the 4% rule to your own retirement? Has the information in this video made you re-think your own retirement-planning rules? Let’s discuss it in the video’s comments.