Have you heard about the 4% Rule and how you can use it to safely make withdrawals from your savings in retirement? It can be a simple rule of thumb to make sure you’re able to withdraw enough money to cover your retirement expenses without needing to worry about running out of money before you run out of retirement. That would not be good.
IN THIS WEEK’S EPISODE
- Overview of the 4% Rule
- Figuring out withdrawing for income or expenses
- Talking about LearnVest and when to seek professional guidance
- Challenges to the 4% Rule and why it’s not a good metric
- Why the 4% Rule does provide a good rule of thumb
- Why 4% might actually be a bit too conservative
WHAT IS THE 4% RULE AND IS IT RIGHT FOR ME?
If you’re just tuning into The Modest Millions Show, you’ll want to catch up on the first few episodes where we cover off on budgeting and some of the principles of the financial independence movement.
Go ahead. Tap pause and go listen to those episodes and then come back. We’ll wait.
Alright, welcome back! Like I mentioned at the top, we’re going to look at the 4% rule from a couple different angles, so we’ll start with a quick overview of the four-percent rule before diving into some of the concerns that some have around this approach and then cover how this rule might benefit you.
I’ve been a fan of the 4% rule for a while, but it wasn’t until I started digging into this topic that I realized how polarizing this topic is. There two very distinct camps, the Fors and the Againsts. There is zero middle ground. The most important thing here, while we review both sides of the debate, is that you might want to consider seeking professional advice to have a professional set of eyes, because your specific situation will definitely dictate whether or not the 4% rule makes sense for you.
So what is the 4% rule?
The “4% Rule” was coined in a 1994 study by financial planner William Bengen. He tested a variety of withdrawal rates against historical rates of return to see how much a person can withdraw over a 30-year retirement without running out of money. It makes sense, right, because in the mid-90s, the average retirement age, was what? 60? 65? a 30-year retirement horizon would take you to 90 or 95 years old, which should have been long enough for your money to outlive you. Bengen found that 4% was the highest rate that held up over a period of at least 30 years. In short, the rule says that you can withdraw 4% of your nest egg in your first year of retirement and then adjust future withdrawals for future inflation. It also assumes that you’re taking moderate risk in your portfolio with 60% in stocks and 40% in bonds. And again, it’s designed to last at least 30 years.
Let’s put some numbers in to illustrate what this looks like. It’s super simple. Rather than working through a convoluted calculation to figure out your number, if your nest egg is $1.75MM, you can safely withdraw 4% of that nest egg every year to cover your expenses, which is $70K per year. Flip the equation around, and if you need $70K per year for your expenses, multiply that annual number by 25 to get the total nest egg that you’ll need: $1.75MM.
So why has the 4% rule gotten so much attention?
Most retirement advisors suggest building a nest egg that is based on living on 80% of your pre-retirement income, which depending on the assumptions that they plug into their system and which calculations they use, means they’ll suggest you save a nest egg of $2-10MM. That’s a really, really big range.
That mirrors some of the variances I’ve seen when I’ve used a few different calculators. What are you supposed to do in that scenario? Roll the dice at $2MM and hope you get a favorable market? Wait until you get to $10MM, which might significantly and unnecessarily delay your retirement? Or, do you split the middle at $6MM? That’s probably where I would land, but it causes a ton of confusion and it’s easy to see why people just kick the can down the road in planning for their retirement or feel that it’s too complicated for them to take control of their own finances. It’s unfortunate.
What’s more, the “80% of pre-retirement income” is a terribly incomplete way to look at what someone might need in retirement, and I wish that wasn’t the calculation that the industry uses.
Why? It’s simple: when you’re retired, you’re most concerned about covering your expenses, right? And, when you’re retired, picking an arbitrary 80% of your income (presumably because you’re not needing to save the suggested 20% of your income for retirement, because, no need to save for retirement when you’re already retired) just seems unrealistic. When you’re retired, you’re going to be in a different tax bracket, if any tax at all depending on your retirement accounts (that’s a different topic for a different day).
Your nest egg should be focused on making sure you have enough saved up to cover your expenses in retirement. Simple as that.
Going a step further, to further drill down into that nest egg number, you need to know (or at the very least closely estimate) what your expenses might be in retirement. Take some time to sit down and design your retirement. From there, project what those expenses might be. Perhaps your mortgage will be gone (or maybe you take a new mortgage for a vacation home), maybe you want to plan for a couple big vacations or going out to eat more often in retirement. If you have kids now, you won’t have kid-related expenses in retirement (except to spoil the grandkids, perhaps?), so your expenses might be less there. But, you’ll need to plan for healthcare, especially if you’re on your employers plan today. You’ll need to self-insure when you retire early, and then when you get older, you’ll naturally have higher healthcare costs, and you may need to budget for long-term care as well. It can be tough to fully estimate that number, but you should sit down and dream and plan. At the very least, it’s very eye-opening.
For instance, in our case, we sat down with our budget (again with the budget, I know!), mapped out what expenses would no longer be around when we’re targeting retirement in our late 40s: mortgage, loans, daycare and school tuitions, diapers, formula, lower grocery bill, etc. All of a sudden, our expenses column was pretty barebones. Then, we added in all the fun stuff we wanted to do in retirement: spend the winters somewhere warm, take some mini vacations throughout the year and spend more on dining and entertainment, along with the not-so-fun retirement expenses like healthcare. From there, we found what those monthly retirement expenses might look like and we could figure out what we need to squirrel away.
Let’s take a quick break and come back to talk about the pros and cons of the 4% rule.
As much as we talk DIY on this podcast, it’s also important to know when to seek professional help. And there’s probably no better episode than this one in which we’re diving head-first into retirement planning to consider a professional. If you do seek professional help, make sure you look for a Certified Financial Planner (CFP, for short). As with any resource, make sure you’re considering your total cost, and thanks to the internet, there are sites like LearnVest. They offer a great free personal finance tracking application that let’s you track and categorize your spending, but the true value is in their professional services in which you work with a dedicated CFP to chart your own personal finance plan. Check it out, play around with the free expense tracking tool and consider some of their offers for discount financial planning.
To learn more and get a special promo rate, visit modestmillions.com/learnvest.
WHAT’S WRONG WITH THE 4% RULE?
Alright, and we’re back.
Let’s talk about the holes that the skeptics poke in the 4% rule.
The first criticism brought forward is that when this rule was first created, it was back in 1994 (over 20 years ago already!), and since then, both retirement ages and life expectancies have grown, so the 30-year retirement assumption may very well be an outdated model. Also, if your goal is an early retirement, your retirement savings will need to last longer than 30 years, rendering the math invalid.
They also argue that the rule was created back when there was a much higher interest rate than today’s low-interest rate environment, which has driven down the value of bonds (which has historically been a key portfolio strategy to mitigate investment risk in retirement).
Another issue with the 4% rule is that over a 30-year retirement (or hopefully longer!), there will be inevitable downtowns, which will mean that a 4% withdrawal rate will more quickly draw down your retirement balance. Such things can happen — the S&P 500 plunged 37% in 2008. If that happens early in your retirement, you’ll either be withdrawing far less than you’d planned on or you’ll be depleting your nest egg faster.
Digging deeper into early-retirement spending, PwC analyzed behavioral trends of retirees to uncover another problem: something called the “sequence of consumption” problem. The 4 percent rule assumes people draw down their retirement balance in a mostly linear pattern (in other words, a flat, inflation-adjusted 4% each year, but life is not linear. PwC noted that retirees often spent more money—much of it discretionary—when they first retire, either because they don’t have a well-designed retirement spending plan or because they are enjoying long-awaited activities such as travel that they opt to splurge when they have a flush retirement account.
Inevitably, discretionary spending tapers off in the middle stages of retirement, and then non-discretionary spending picks up later on, perhaps because of health-care needs. But households who overspent in the early years can wind up in a bind at that point.
PwC’s findings add to concerns about the viability of the 4 percent rule.
A 2013 study found that using historical interest rate averages, someone following the 4% methodology had only a 6 percent chance of running out of money. That’s exciting odds, no? But using interest rate levels from January 2013, when their study was published, the authors found that retirees’ nest egg would grow so slowly that the chance of failure rose to 57 percent, throwing shade on the 4% theory.
WHY THE 4% RULE STILL WORKS
While we’re fresh on the topic of these studies, it’s a good time to shift gears and counter these criticisms of the 4% rule.
The challenge with the 2013 study is that it used a moment-in-time interest rate study of 2013 to project across an entire retirement.
Whether we like it of not, the financial market is cyclical, which means that over the course of a retirement, you’ll likely have some lean years, but there will also be some flush years where your returns blow past projections. It’s short-sighted to take a shorter time period and project it across a 30-year retirement or longer. And, if you’re looking at a point-in-time study like this one, it would really only be applicable if you’re retiring today. Instead, if you’re planning for a retirement 15-20 years from now, the interest rate environment will likely not still be deflated like it is today. In fact, the Fed has already stated their intentions to raise interest rates three times in 2017, indicating that this low-rate environment is nearing an end.
Taking an historical view, financial planner Michael Kitces noted that when you go back all the way to the 1870s, more than two-thirds of the time a retiree following the 4% rule would have had more than doubled their starting principal at the end of 30 years. Additionally, less than 10% of the time does the retiree ever end up with less than their starting principal, and that even includes retirees who would have started their retirements in 1929, 1937, 1965 and 1966, when returns have bottomed out.
In fact, in the years since he published his paper, William Bengen has since refined his initial position and with a more diversified portfolio, he later raised the safe withdrawal rate to 4.5%.
There was another big study that was conducted, called the Trinity Study, in which they analyzed what would have happened for a hypothetical person who spent 30 years in retirement between the years 1925-1955, 1926-1956, 1927-1957, and so on. They assumed the retiree had a balanced portfolio of 50% stocks and 50% 5-year US government bonds. Then they required the retiree to spend an ever-increasing amount of their portfolio each year, starting with an initial percentage, then indexed automatically to inflation as defined by the Consumer Price Index (CPI). Since the study was published, it has been updated, tweaked, and reported on by a guy named Wade Pfau. He created a useful chart showing what the maximum safe withdrawal rate would have been for various retirement years.
What it shows is that the 4% value is actually somewhat of a worst-case scenario in the 65-year period covered in the study. In many years, retirees could have spent 5% or more of their savings each year, and still ended up with a growing surplus.
The trinity study assumes a retiree will:
- Never earn money through part-time work or side hustles
- Never collect from social security or any other pension plan
- Never adjust spending to account for economic reality like a huge recession
- Never collect any inheritance from the passing of parents or other family members
- Spend at the same level for the duration of their retirement, without any natural decreases in spending as we age
When you consider those numbers, it’s clear that the 4% rule is meant to take the worst-case scenario and extrapolate it out over 30 years, which just isn’t the case.
Take the “recent” dot-com crash in 2000 and the Great Recession in 2008. Would it have sucked to start your retirements during those years? Yep. No doubt about it. But, take 2008. It looked really bad for a year or two when the Dow Jones dropped from a peak of 14,000 to around 6,500 in 2009, until skyrocketing to over 16,000 in 2014 and to over 20,000 in 2017. Hopefully you were in a position to buy low in 2009. We, regrettably, were not…
You can also address the stock market-volatility issue by being flexible. Withdraw less than 4% in bear markets and more than 4% in bull markets.
Of, if you think you stand a decent chance of living more than 30 years in retirement, and you want to be extra cautious, you can be more conservative, perhaps using a 3% or 3.5% withdrawal rate — at least in your initial years. That can be helpful during our low-interest rate environment, too.
In fact, even with an ultra-conservative allocation, there’s almost a safe withdrawal “floor” where 3.5% safe withdrawal rate that projects to last in perpetuity even past the planned-for 30-year target horizon, even when you take a very conservative bond-heavy allocation.
The 4% rule includes adjustments for inflation, which is great, but you may further protect yourself from inflation creep by investing in an inflated-protected assets like real estate, which increases in value to match inflation, as do stocks, to a certain point, so I don’t get too hung up on calculating inflation in retirement calculations. Short-sighted? Perhaps, but given that the 4% rule is already accounting for inflation and there are other hedges against inflation, I won’t ever sit in front of a retirement calculator and plug in desired retirement income in today’s dollars and an inflation rate of 2-3% and watch my required nest egg grow to a billion dollars in “tomorrow’s dollars.” I don’t buy it. I usually like to take the conservative approach when it comes to financial planning, but even that is a little too doomsday-ish.
Another factor to consider is that depending on your portfolio, there are some things you can do to minimize your income tax bill in your retirement. You might consider investing (or converting) into Roth accounts so you don’t pay any taxes on that portion of your income in retirement. Or, by being strategic with your investment plan as you near and enter retirement, you can likely take some steps to further reduce your tax bill and minimize the withdrawal you need. Your CPA will help with that.
Another tip is to closely watch the fees you pay to manage your accounts. If your accounts are actively managed, you’re paying anywhere from 1-2% to manage that money. If you go for a more DIY approach and invest in ETFs, or exchange-traded funds, that closely match an index like the S&P500, you might not get the chance for exceptional returns that you might get in an active fund, but over a long time horizon, might closely match an actively-managed mutual fund. With the ETF route, since there at not actively managed, there fees are much less, so you might only pay 0.25%. Said another way, if your actively-managed fund from your advisor costs 1.5% and yields an 11% return, but your ETF fund that you got from Vanguard charges 0.25% and goes stride-for-stride with the S&P500 to yield 10.5%, your effective net yield is 9.5% versus 10.25% in favor of the ETF fund, leaving you an extra 0.75% in returns, especially relevant when you’re talking about a number like a 4% withdrawal rate in retirement.
Alright, deep breath. Let’s bring home. Here’s an important consideration when it comes to the 4% rule: don’t set it and forget it. Your spending patterns in retirement will vary, not only depending on your spending preferences compared to someone else’s, but also inside your own retirement. As Paul Palazzo, a certified financial planner in New York puts it, there are three stages of retirement: go-go (think of early retirees traveling the world), slow-go (hanging out with the grandkids) and no-go (dealing with long-term care). You’ll likely want to spend more in the go-go stage with increased discretionary spending and in the no-go stage with increased non-discretionary expenses, and spend less in the slow-go stage as you stick around to spend more time with the grandkids.
Also, you need to monitor the larger market trends. If we’re entering a bear market, consider dialing back some of your discretionary spending or dial up your side hustle or part-time work, effectively needing to draw less from your nest egg and lowering your effective withdrawal rate. Or, if we’re in a long bull market, you might want to consider capitalizing on those flush years and splurge a little more. Point being, don’t be a stick in the mud and feel like you need to stick to a 4% straight withdrawal. You need to be a bit more flexible, which I’ll admit isn’t the easiest approach for me.
What about you? Have you looked into the 4% rule? What’s been your experience? How has it gone? I’d love to hear from you.
Also, make sure to reach out with your feedback for me or for the show, topic ideas, personal anecdotes of your own journey or if you just want to say hi. You can always reach me at feedback[at]modestmillions[.]com.
For a recap of the strategies, tools and links that we talked about today, check out the show notes at modestmillions.com/004.
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Join me next week when we begin exploring the differences between traditional and Roth retirement accounts.
Until then, remember to keep squirreling away now to earn millions later!
Thanks for listening; we’ll see you next time!