Beware of oversimplification. As Albert Einstein wisely stated, “Everything should be made as simple as possible, but no simpler.” Nowhere is this truer than the conventional wisdom in retirement planning. The “4% rule” became the oversimplified “truth” for safe withdrawal rates after published academic research showed it was the maximum you could spend from savings without excessive risk of failure. It became widely accepted because it was reasonably plausible, easy to understand, and simple to implement.
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In short, it solved a complex problem with a simple solution (which is always appealing).
But is it really true? Is the 4% rule really safe or could it put your retirement security at risk?
A Quick Primer on Safe Withdrawal Rates
It’s a question everyone must confront sooner or later: How much income can I withdraw from savings without running out of money before I run out of life? Knowing your safe withdrawal rate is arguably the most important issue you will face in retirement planning because it literally determines…
- The lifestyle you can afford.
- How much you need to save for retirement to support that lifestyle.
- The risk of going broke if you get it wrong.
The 4% rule attempted to answer that question by applying a simple rule based system using the following assumptions…
- Invest in a conventional diversified portfolio of stock and bond indexes like the S&P 500.
- Withdraw 4% of your savings in the first year you retire.
- Adjust that first year withdrawal by inflation each year after (usually upward).
- Rinse and repeat until you die (or run out of money).
According to the “experts” your risk of outliving your savings applying this simple formula is small.
But sometimes experts are wrong…
7 Reasons to be Cautious About Safe Withdrawal Rates
The 4% rule is an old-world model that represented a breakthrough in knowledge for its day, but is desperately in need of an update now. The latest academic research on the subject is rapidly invalidating the old model with many new insights into how safe withdrawal rates actually work.
The problem for most investors is the new research remains inaccessible or hard to comprehend. That is why I recently compiled a readable summary of the latest findings in safe withdrawal rate research here so that you can understand these issues.
Below are 7 specific points of concern taken from the research to help you understand problems with the 4% rule and the direction to look for solutions:
- 4% safe withdrawal rates are based entirely on U.S. investment data from a period when the U.S. was the “prom queen” of the economic world. This created an optimistic bias to the research results. Subsequent research applying international data has verified this concern by showing a 100% risk of failure – a shocking result to say the least.
- The actual safe withdrawal rate you will experience in retirement is highly dependent on the inflation rate and the first 10 years sequence of investment returns. What this means is true safe withdrawal rates vary widely depending on when you retire – one size does not fit all.
- Actual safe withdrawal rates show a correlative relationship to investment market valuations, interest rates, and inflation at the time you begin your retirement. In other words, safe withdrawal rates are dynamic – not static – and can be adjusted based on economic indicators during your actual retirement to provide a more accurate estimate.
- Blindly increasing your withdrawal rate annually to compensate for inflation (as typically modeled in the research) is only sustainable in a stable inflation environment (roughly 3% or less). Periods of higher inflation (1970’s in the U.S. or other international data) showed withdrawal rates growing to an unsustainably large percentage of savings. Given unprecedented government debt levels this should raise serious concern for every retiree.
- The longer your life expectancy the lower percentage you can safely withdraw from savings. Given increasing longevity with 90% confidence intervals for healthy couples at age 65 already exceeding 100, every retiree must be extremely cautious about any strategy that amortizes savings by spending principal. By definition, any withdrawal rate that spends principal over a 30+ year time horizon is not safe.
- Most safe withdrawal rate research supporting the 4% rule assumes zero fees and expenses by applying cash index data to a traditional asset allocation of stocks and bonds. If you invest in low cost ETF’s without additional investment advisory fees then you may be able to ignore this issue because the impact is minimal. However, if you invest with an advisor using expensive mutual funds then this issue is a serious consideration that could reduce your safe withdrawal rate by 10%-20% when compared to research. Similarly, if you invest in a non-traditional asset allocation then the research is completely irrelevant to your situation.
- Safe withdrawal rate research usually assumes you blindly increase spending throughout retirement based on inflation. Rational retirees behave differently. They increase spending as their portfolio grows and decrease spending when it declines. They also reduce spending as they age thus largely offsetting inflation. The truth is risk of ruin is just as dependent on retiree behavior as it is on market dynamics – something not considered by the research. You can’t determine the safe withdrawal rate for rational retirees from a model based on irrational behavior.
The 4% rule as a model for safe withdrawal rates is not really safe. It gives an oversimplified approximation to how much money you need to retire based on dubious assumptions that could cause you to leave a fortune on the table or run out of money long before you run out of life.
Neither of these alternatives is acceptable.
Your actual safe withdrawal rate will likely be very different from the 4% rule depending on your retirement date, spending patterns, health, and investment strategy. It might be higher… or it could just as easily be lower.
Be wary of oversimplified answers to complex questions. Even though it is conventional wisdom the truth is actually far more dynamic.
It would be one thing if the margin of error was small and the consequences were manageable, but it’s not. The risk of ruin for the 4% rule can be large, and the compounded effect of small errors in safe withdrawal rates can be so dramatic it can cause you to go broke or leave significant wealth you could have enjoyed.
The reality is you will spend your entire career saving for retirement so it probably makes sense to spend a few minutes developing a deeper understanding of how safe withdrawal rates really work.
It is critical to your financial security in retirement, and it is far too important to trust to oversimplified rules-of-thumb.