Avoid the 4% Rule to Stay a Millionaire in Retirement

It’s nearly impossible to set sail into the early retirement waters without hearing the siren call of the so-called 4% Rule.

The allure is intoxicating: A simple calculation that tells you precisely how big your doughy nut has to be in order to retire…and never fear running out of funds.

But the siren’s wail has a dark side as well, and if you’re not careful with heuristics like the 4% Rule, your doughy nut can run across some pretty gnarly rocks in the economic seas. And nobody likes gnarly rocks on their nuts.

So, let’s slap the 4% Rule around FL style and find some glorious, glistening, super-doughy financial nuggets lurking under the 4% Rule’s fleshy folds.

First, a sneak preview of what’s to come here:

  • The 4% Rule is neither as powerful, nor as useless, as some early retirement commentators might lead you to believe.
  • There’s a very simple way to fix an important shortcoming of the 4% Rule to ensure our doughy nuts keep afloat in even the most treacherous financial seas.
  • Understanding a bit more about the 4% Rule and its ilk means we lay the foundation for making our doughy nuts as big and buoyant as possible.
Don't Hold Your Retirement Breath with the 4% Rule
Don’t hold your retirement breath with the 4% Rule.

The 4% Rule

The 4% Rule gives us a simple heuristic to base our freedom number on. And it’s been popularized to mean that, as long as our annual expenditures are 4% or less of our retirement portfolio, we never have to worry about money again.

That’s kind of right, but also kind of wrong.

In actuality, the 4% Rule tells us two key things. First, in our initial year of retirement, we can withdraw 4% of our portfolio value. So, if we have a $1 million portfolio, we can draw out $40,000 that first year.

And second, it tells us that, in subsequent years, we can withdraw the same dollar amount (adjusted for inflation; say $40,400 in year two, reflecting a 1% inflation rate), and so on, forever.

Following this rule, we are not likely to run out of funds before we die.

Take a good, hard look at the soft pastiness of that language. Not likely? Not likely?!? What in the F(L)?

Um, pray tell good sir, why ought “likelihood” exist when we demand clear “certainty”?

So let’s take the 4% Rule out for a nice chicken dinner, understand where it’s coming from a bit better, and see if we can’t get closer to “certainty” and a bit farther away from gambling.

The 4% Rule was initially developed a couple decades ago as a financial planning tool, based on some empirical back testing using 100+ years of U.S. market data.

Herr Bengen, the author of the rule, wanted to advise new retirees on withdrawal rates from their portfolios such that they wouldn’t run out of money.

So he constructed a bunch of hypothetical retiree portfolios, each comprised of 50% stocks and 50% intermediate-term treasuries, with withdrawals at various rates commencing each year from 1926 through 1976. He then determined how long each portfolio would last before running dry.

What happens when your portfolio runs dry.
What happens when your portfolio runs dry.

In this way, he built into his analysis the vagaries of market returns, booms and busts, Fed action, etc. – that is, all the same stuff any new retiree would face.

To illustrate Bengen’s approach, consider one hypothetical retiree in the study’s analysis. She would exit the workforce in 1950 and withdraw from her account 4% that first year. In each subsequent year, she would withdraw the same amount (adjusted for inflation) for as long as the funds lasted. Another retiree would start doing the same thing in 1951. Another in 1938. Another in 1969. And so on.

Other portfolios were tested with higher and lower initial withdrawal rates – up to 7%, and down to 1%.

And the conclusion: At an initial withdrawal rate of 4%, you “should be safe.” That is, a 4% withdrawal value, increased each subsequent year by inflation, never caused a portfolio to run dry in less than 33 years. Most of the time, the portfolios lasted 50 or more years.

Hmm… for a crusty “normal” retiree, that may be good enough. But for a vigorous and peppy Financia Luchador, aged only 35 or so, a portfolio’s gotta last more than 33 years. (We hope. And since we value ridiculously amazing health around here, it really ought to last more like 70 years – and have a bunch of digits still rolling around for our offspring.)

So let’s order the 4% Rule a little dessert wine. Is there any way we can ensure our portfolio lasts at least 50 years, a time horizon more befitting our demographics, according to Mr. Bengen’s analysis?

The 3.5% Rule

It turns out there are two critically important nuggets buried in the paper that tell us there is.

The first:

“…an ‘absolutely safe’ initial withdrawal level is 3 percent, in that it ensures that portfolio longevity is never less than 50 years. (This is also true for withdrawal rates as high as approximately 3.5 percent.)”

Okay. So we give up a half a percent of drawdown (going from 4% to 3.5%) to gain a boatload of certainty? That’s one fine piece of ace.

Another beautiful Bengen nugget shines bright like a diamond. Bengen unwinds his initial investment allocation assumption and shows us what happens if our initial portfolios are not 50% stocks but rather as little as 35% stocks or as much as 75% stocks.

“As [we consider these different allocations], the increase [in] wealth is dramatic – as much as fourfold for some scenario years. The average portfolio value increase from 35-percent stocks to 75-percent stocks is +123 percent.”

That is, if we’re more heavily invested in stocks – up to, but not more than, 75% of our total holdings, according to Bengen – our portfolios fare much better. The portfolio’s longevity is enhanced, and the total value grows. Check and check.

Okay, so to recap: For our purposes, the 4% Rule should really be called the 3.5% Rule. And we need the right portfolio mix to make our dollars do the most work for us possible while minimizing our risk. A 75% stock allocation, with the balance in treasuries, seems to do the trick.

It’s all so simple you might be wondering why I bothered explaining Bengen’s analysis when I could have just sputtered out “3.5% withdrawal rate” and “75% stock allocation” and called it good.

The 4% Rule Is Dead

Well, more recently, a trio of wisecrackers named Finke, Pfau and Blanchett decided to spoil the party, and their analyses got a bit of press that sent the less steely of us into a bit of a tizzy.

Using some good, as well as some occasionally weird, empirical methods, these guys showed that maybe the usefulness of the 4% Rule (or even something like our 3.5% Rule) wasn’t so much.

In fact, Pfau claimed the 4% Rule’s apparent validity really was just an artifact of aberrant market conditions that persisted during Bengen’s period of analysis in the U.S.

Hmmm…Maybe. We’ll get back to this one.

Later, in 2013, the Finke, Pfau and Blanchett trio published a paper that evaluated the success of the 4% Rule in an environment of low interest rates (like the one we’re in now).

Using various withdrawal rates and various assumed levels of future stock and bond returns and various levels of stock/bond portfolio allocations, they showed very high “failure” rates of retiree portfolios. That is, rather than any “absolutely safe” portfolios, the three demonstrated that no fewer than 1 in 5 portfolios would run dry in 30 years or less – with a withdrawal rate of just 3 percent and a 75 percent stock allocation!

What in the what?

But I thought we could pull out 3.5% and never run out of money!?!? What gives, FL? Show me the light!

Reports of the Death of the 4% Rule Are Greatly Exaggerated

Before we curl into the fetal position and soak the floor, let’s understand a few things about these guys’ findings.

First, regarding Pfau’s assertion that the 4% Rule’s initial formulation is based on aberrant market data: Pffffff(au).

It turns out Pfau based this conclusion on international data, and it’s unlikely (in my mind) the American economic success story is over, so I think the study’s essential framework is shaky to begin with. Economic success tends to beget economic success; it doesn’t really tend to work the other way around. So, rather than believe that, because the U.S. has been so economically successful in the past it’s going to certainly be less economically successful in the future, it’s more likely that the U.S. will continue to be successful simply because it’s been successful in the past.

Moreover, 100+ years of historical performance in U.S. markets really can’t be outright ignored in favor of data from other countries, particularly when we’re considering the U.S. market for our retirement planning.

Which kind of makes you want to go ahead and think Pfau, et al.’s findings are all a bit overheated.

But we’re careful here at FL, so let’s not dismiss Pfau and team too quickly. Let’s simply invite them all into the ring and see what happens.

Let’s first turn to the dream team’s findings that even a 3% withdrawal rate will put lots of portfolios in jeopardy. Here, when you get past the study’s headlines and prefatory prose, you find that the conclusions simply assume negative real interest rates in treasuries – that is, they assume investors lose money every year they’re invested in government bonds. They also just assume some uncharacteristically low stock market returns.

It’s not hard to construct hypothetical scenarios that seem really bad when you basically take as given that the wheels are going to fall off. Let’s assume for a second you’re a colossal dunce…

Yes, the authors would contend they based their assumptions on prevailing market conditions at the time of the paper’s publication, but their arguments are weaker than OJ Simpson’s moral fiber, some of their methods are questionable, and their conclusions are little more than alarmist.

For a bunch of reasons, I’m throwing down a big time suplex on their clucks and squeals and suggesting we not get too upset by all the squawking.

For one, the assumed low returns on stocks and bonds basically drive the results. These assumptions are troubling not only because they’re historically out of whack, but because they also assume investors are stupid cows who will keep holding money, year after year, in assets that are costing them ruinous losses. Investors aren’t stupid cows. Even cows aren’t that stupid.

Second, the analysis (and the other studies mentioned, for that matter) ignores asset classes other than stocks and t-bills. You can’t invest in real estate, commercial paper, peer-to-peer loans, any international listings, or other “alternative” investment vehicles. Yes, this assumption is built into Bengen’s analysis, so it’s part of the analytical history of all this, but it’s not realistic and it serves to underestimate returns and overestimate portfolio volatility and risk.

Finally, there are some technical issues with the way inflation gets treated and some problems with the assumed constancy of drawdown in the face of economic trouble. But whatever: the big analytical problems are the first two, and they’re enough to rain down merciless elbows and knees on reports of the death of our 3.5% Rule.

Adios, Pfau and pals.

So where’s all this leave us?

3.5% > 4%

For purposes of planning your retirement and sizing up your doughy nuts, look first to the 3.5% Rule. It’ll give you a number that then can be allocated strategically.

But we’ve also been enriched by this lively discussion of Bengen, Pfau and others. So there are a few important additional takeaways and research findings that ought to be mentioned.

Takeaway Numero 1:

Even in research that is essentially skeptical of the 4% Rule, a 3.5% initial withdrawal rate regularly is shown to be safe and is treated as a valid benchmarking tool.

So it’s fair for us to use a 3.5% figure (i.e., 28.5x multiplier) on our annual spending to give us a first-cut portfolio size for our magic number.

Takeaway Numero 2:

Investing in government treasuries is not a great way to build and preserve wealth in retirement. For very, very large investors (like countries), holding treasuries can be part of a useful strategy. But for individuals, especially in this low interest rate environment, it’s quite valuable to stay away.

So as we construct financial portfolios that are built to bust us free of mandatory work, we’ll look away from gummint bonds.

Takeaway Numero 3:

Allocating the majority of our holdings to U.S. stocks is a useful part of a retirement strategy. Especially when it’s done right to properly take advantage of diversification benefits and minimize transaction costs and maintenance costs, which can stealthily eviscerate big chunks of portfolio value.

Takeaway Numero 4:

Strategic investing in “alternative” asset classes can be a critically important submission hold in the arsenal of wily Financia Luchadores for successful financial outcomes.

Takeaway Numero 5:

Annual rebalancing of portfolio holdings is important in maintaining wealth.

We’ll kick these topics around another day, but no discussion of constructing a safe retirement nut is complete without them. So consider yourself welcomed.

Now get out there and get intimate with your portfolio already.

In an upcoming post we’ll gently caress the 3.5% Rule and its mechanics for figgerin’ out the precise radius your doughy nut needs to set you free.

Until then, Luchadores, drop a comment about any other rules-of-thumb you use for retirement nest egg planning or benchmarking.

(Update: Read about the latest empirical research on the 4% Rule, inflation and safe withdrawal rates that allow you to build wealth in retirement.)

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