The Creator of the 4% Rule Doesn’t Follow His Own Advice

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  1. The rule of thumb that looks good on paper
  2. Rules of thumb are a good place to start but a terrible place to stop learning about finance
  3. Why it’s difficult to execute any withdrawal strategy
  4. Sequence of returns risk: what if you have bad luck?
  5. Longevity risk; what if you live too long?
  6. Inflation risk; what if my purchasing power goes down faster than expected?
  7. What is an annuity?
  8. Why economists love annuities
  9. Become A Rational Investor
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As the great Mike Tyson once said;

Everyone has a plan until you need to start withdrawing from your portfolio without a paycheck.

Of course, that is not the actual quote, but Tyson’s point applies to a very important financial reality we all have to deal with:

Creating a financial plan in a spreadsheet is easy. Following through on that plan and pinning your quality of life in retirement to that plan takes a tremendous amount of courage and unwavering belief in the plan.

When paychecks stop coming in, financial planning gets scary

Saving for retirement in your 30s is an intellectual exercise. Executing the plan in your 70s is an act of faith

  • You make a plan (ideally) in your 20s or 30s, knowing you don’t have to execute the plan for another thirty or forty years.
  • A portion of every paycheck gets siphoned off to a retirement account.
  • The whole process runs on autopilot, and you basically forget about it.
  • Until one day, the paychecks stop coming in, and it’s time to execute the plan.
  • That’s when it dawn’s on you; executing the plan means slowing spending down the nest egg you spent your entire life building.
  • You’ve read all kinds of books and articles about how to save for retirement, but you quickly realize nobody ever told you how to spend in retirement.

That’s when fear and panic kick in.

The rule of thumb that looks good on paper

I’m a fan of financial rules of thumb, but only if they are used properly.

Rules of thumb can be effective educational tools. They help take a very complex problem — like how to live off your savings for 30 years — and boil it down into a very simple 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. 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 that 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. The Trinity study found that a 4% withdrawal allowed retirees a 95% chance of not running out of money.

Rules of thumb are a good place to start but a terrible place to stop learning about finance

Like any rule of thumb, the 4% rule is an oversimplification of 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 a 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.

Why it’s difficult to execute any withdrawal strategy

We know two things to be true about the stock market.

  1. In the long run, it goes up.
  2. It doesn’t go up every year.

The volatility of the stock market is not such a big problem when you are still working and have a paycheck coming in every two weeks.

But once you reach retirement and your only source of income is your portfolio, it becomes more difficult to fully trust in the models and projections that try and assure you everything will be alright in the long run.

There are limitations to the human brain's ability to remain rational.

More importantly, feeling uneasy about blindly trusting a rule of thumb like the 4% rule is not irrational. It’s a sign you are aware of the very real risks such a simple plan presents.

Let’s focus on the risks that a rigid withdrawal strategy presents.

Sequence of returns risk: what if you have bad luck?

Historically, the U.S stock market has gone down 4 out of every 10 years.

Again, not a problem when you’re working.

But what happens if the market drops — potentially a lot — in the first year, you start withdrawing 4% of your portfolio?

Financial experts have labeled this “sequence of return risk.”

  • During your working years, if the market drops, it’s an opportunity to buy.
  • When the market drops in retirement, not only can you not buy, you are forced to sell.
  • If the market drops in your first few years of retirement and you continue selling to fund your lifestyle, by the time the market recovers, you may not have enough left to fully enjoy that recovery. This puts your retirement in jeopardy.

Let’s put some numbers to what this might look like.

Let’s say you retire with $1 million invested in a 50/50 portfolio of stocks and bonds and you plan on using the 4% rule and sell $40,000 worth of assets in year one of retirement.

Then, out of nowhere, the stock market crashes, and your portfolio loses 30% of its value a few months into your retirement. Add in the $40,000 you withdrew to fund your retirement, and after one year, your $1 million retirement nest egg is down to $660,000.

In the first year of retirement, 34% of your nest egg is gone.

In year two, you increase that $40,000 withdrawal by the rate of inflation, and you keep increasing that withdrawal by the rate of inflation in each subsequent year. The longer it takes for markets to bounce back, the less savings you have left.

Sequence of returns risk is the risk that you get unlucky, and your investments perform very poorly in your first few years of retirement.

Longevity risk; what if you live too long?

A thought that only an actuary would have.

But a concern when living off a portfolio of investments is how long you think you’ll live. The 4% rule was modeled on the assumption that your retirement lasts 30-years. Each subsequent year you live increases the risk of running out of money.

The good news and the bad news is that people are living longer.

Here’s some data from the U.S Census Bureau.

  • In 1960 the average life expectancy was 69.7 years.
  • By 2015 the average life expectancy increased to 79.4 years.
  • By 2060, the projected life expectancy is 85.6 years.

Longevity risk is magnified by sequence of return risk. If you plan on a 45-year retirement and the market crashes in your first year of retirement, the odds that you will outlive your money will skyrocket.

Inflation risk; what if my purchasing power goes down faster than expected?

Here’s another problem with a rigid withdrawal rule; you must make assumptions in your 30s about the inflation rate in your 70s and 80s. Which, of course, is unknowable.

Most retirement calculators and financial planners assume a constant 2% or 3% inflation rate. But what if inflation is higher when you reach retirement?

Here’s how much $100,000 is worth after 30-years under various inflation rates.

  • 2% → $55,207
  • 4% → $30,832
  • 6% →$17,411

The rational investor knows that the stock market has a decent track record of outpacing inflation, but bonds do not. The more bonds you have in your portfolio, the more a higher than expected inflation rate will destroy your wealth. A 50/50 portfolio (which the 4% rule is modeled on) is exposed to the risk of higher than expected inflation.

Allocating more of a portfolio to stocks can help address inflation risk, but that increases sequence of return risk given the volatility in the stock market.

Pick your poison.

What you need is guaranteed income in retirement

Guaranteed income is income you will not outlive.

Defined Benefit pensions are a great example of risk-free retirement income. So are government programs like Social Security in the U.S or the Canada pension plan in Canada.

If you have enough guaranteed income in retirement to cover your essential spending needs, you don’t need to worry so much about sequence of return or longevity risk.

Guaranteed income is like having a very secure paycheck in retirement. This allows you to take a rational long-term approach to your portfolio in retirement.

  • If the stock market crashes in year one of retirement, it’s no big deal because you have enough guaranteed income to ride out a bear market.
  • If you live to be 125, you don’t have to worry about eating cat food in your final years because you have guaranteed income that lasts as long as you do.
  • In an ideal scenario, you’re guaranteed income accounts for inflation, so you don’t need to worry about loss of purchasing power.

If you don’t have a Defined Benefit pension, you can use some of your financial assets to buy one.

How is this possible?

By using one of the most-hated but rationally sound financial products; annuities.

What is an annuity?

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.

As part of the terms of the agreement, you can specify how long you want those payments to last.

  • If you believe you will only live for another 25-years, you buy an annuity that pays you every month for 25 years.
  • If you think you’ll live for a very long time, you can buy an annuity to pay you every month until you die.

The longer you want guaranteed income to last, the more expensive the annuity will be.

People have written entire books on annuities, so it’s beyond the scope of my work to dive into all of the nuances and complexities of annuities — of which there are plenty. The details of the contacts and the fees involved can vary significantly.

Dealing with issues like annuities is where a fiduciary financial advisor is worth their weight in gold (or better year, in globally cap-weighted index funds).

Why economists love annuities

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 what economists want to do is 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.

In the same way, a 30-year-old with a secure paycheck every two weeks can stay invested during turbulent markets, so can a 70-year-old with a guaranteed monthly income.

To be clear, buying guaranteed income can be quite expensive.

Think of an annuity-like an insurance policy; you pay the insurance company, and in exchange, you get to transfer sequence of return and longevity risks to the insurance company.

Whether you are buying car insurance, life insurance, or an annuity, all you are doing is paying a company to take certain risks off your plate and putting them on theirs.

Buying an annuity comes with opportunity costs.

The first is the lost growth potential of your portfolio. Trading in a large portion of your retirement nest egg in exchange for guaranteed income means you won’t accumulate as much wealth if financial markets perform great during your retirement.

An obvious implication of dying with less wealth means you will have less of a financial inheritance to leave behind.

Annuities are simply a tool to manage risk.

You do not have to trade in all of your assets to buy one. Depending on your level of wealth and the amount of guaranteed income you want in retirement, you could trade in anywhere between 1% to 100% of your financial wealth.

Having a baseline level of guaranteed income and leaving the remaining portion in a diversified portfolio to grow in the future is a rational way to manage risks, ensure you enjoy the retirement you’ve worked for, and still leave behind a financial inheritance.

Building wealth requires you to take on investment risk.

Living off wealth requires you to manage investment risk.

This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.