What’s the best part about having rules?
Breaking them.
From curfew to grammar to math to strategy, breaking the rules leads to unique experiences and opportunities.
When you plan for retirement, there seems to be a never-ending litany of rules guiding you along your path. But some rules were made to be broken.
I hate to put you back into high school English class but do you remember the famous grammar rule “i” before “e” except after “c”? Did you also know that more words break that rule than follow it?
See, sometimes being a rule-follower can limit your point of view (or the words you use).
Today, we’ll talk about why you might consider breaking perhaps one of the most famous retirement rules out there: the 4% rule.
- What’s the 4% rule?
- How does it work
- Should you break it?
Let’s dive in.
Breaking Down The 4% Rule
In 1994, Bill Bengen published a paper that would change the way people talked about retirement income planning forever.
No, we’re not just being dramatic.
In this paper, Bengen coined the term the 4% rule, a strategy that people would disseminate and debate for the next 28 years and counting.
So, what is this rule, anyway?
The 4% rule is a retirement income calculation meant to help retirees strike a balance between withdrawing enough to support their lifestyles but not too much that they’d run out of money sooner than planned.
According to Benegen’s research, the safest amount of money you could withdraw from your portfolio was 4%. In subsequent years, you’d factor inflation into your withdrawal plan. For example, in year one, you’d withdraw 4%, in year two, it could jump to 4.2%, and so on.
While a solid starting point, we believe that the increase in the withdrawal rate is misunderstood. In practice, you might not need to increase your withdrawal rate every year, even factoring inflation into the mix.
Instead, think about it in these terms.
A portfolio in stock will typically outgrow the 4% rate of withdrawal most years, so the dollar value of the increase will occur naturally.
But the bigger challenge is to restrain hefty initial expenditures since, for many, this is the first time you’ll have a pile of money and the need to manage it. While it may feel so easy to spend $100,000 when you have $3 million in your nest egg, it’s not without its consequences.
We work with you to understand the long-term impact of spontaneous spending and excessive withdrawals throughout retirement.
Getting them to see the long-term impact of excessive withdrawals as part of our work. Further, the closer you are to mortality, the better able you are to withstand a higher withdrawal rate since you won’t need it to last as long. But as we say, just don’t get the date wrong!
How Does The 4% Rule Work?
Bengen complied and analyzed market data over a 50-year period from 1926 to 1976. His primary focus was on stock and bond returns throughout this segment.
And that period was ripe with challenges, downturns, and bear markets.
His work found that even in the most irregular market conditions, there was no scenario where withdrawing 4% wasn’t “safe.” And by safe, he meant that taking out 4% never depleted a retirement portfolio in less than 33 years.
Sounds pretty good, right?
Remember, simple answers are often a product of simple questions. While this rule may have been an excellent rule of thumb, there are several circumstances it doesn’t account for.
And you live in the nuance—your retirement plan won’t be the same as anyone else’s because your goals, values, and vision for your life aren’t a carbon copy.
The “Perfect” Portfolio To Support The 4% Rule Doesn’t Exist, Here’s Why
To work the way the research suggests, there are some considerable assumptions you have to make about your portfolio construction, lifestyle, longevity, and more.
Here’s what the headlines don’t clearly tell you.
The 4% rule operates best under the following conditions.
You have a portfolio allocation of 60% stocks and 40% bonds.
Everyone has different needs and goals heading into retirement. But the 4% rule doesn’t take those differences into account.
One of the rule’s biggest assumptions is the type of securities you invest in long-term. Bengen based his calculations on a portfolio allocation of 60% stocks/equities and 40% bonds/fixed income.
If you invest differently, the 4% rule won’t apply as cleanly to your portfolio. Why? Because by deviating from the playbook, you produce different results.
But this doesn’t mean that a 60/40 split is the right call for you. You should base your asset allocation on several factors:
- Risk tolerance and risk capacity
- Time horizon
- Retirement lifestyle goals
- Income and cash flow plan
For example, your risk tolerance may not be what it was in your 20s; for some people, a 60/40 split may seem too aggressive. Conversely, bond returns aren’t performing as they did a few decades ago, so investing such a significant portion into bonds may curb net returns.
Another flaw is that the 4% rule only accounts for portfolio income. This means that it doesn’t consider other critical retirement income sources like Social Security benefits, pension, real estate, cash, etc., all of which can make a considerable difference in how much you can spend in your golden years.
Your spending must remain consistent.
With the 4% rule, you withdraw the same amount of money from your portfolio year over year (while accounting for inflation).
So that means the rule expects you to spend the same amount every year. But that assumption doesn’t translate nicely into people’s real lives. The truth is that many people spend inconsistently throughout retirement.
Typically, people approach the first few years of retirement with a “have money to burn” mentality. These are big-spending years because people often make significant changes—a cross-state move, snowbirding, buying a “dream” object, increased travel, a greater focus on entertainment, “bucket-list” worthy activities, etc.
Spending often tapers out once people make these more sizeable purchases/life changes. But then it picks back up again as people age and are met with increased health needs.
The 4% rule isn’t elastic or dynamic enough to consider these significant life changes that occur throughout retirement.
You plan on being retired (and drawing from your accounts) for a certain amount of time.
A major roadblock standing in the way of people’s retirement portfolios lasting a lifetime is increased longevity.
As a whole, the longevity trends for the United States have increased since 1980—with a few stumbling blocks in 2020 and 2021 (understandably so). The longer people live, the longer they need their retirement savings to support them. This factor has presented unique challenges and considerations when saving for retirement and spending while in retirement.
As you’ll recall, the 4% rule operated well for fewer than 33 years. So what if you need your retirement savings longer?
This scenario is more common than you might think!
With people leaving the workforce earlier than usual—whether due to personal choice, pandemic-related layoffs, etc.—and living longer, there’s a good chance that people are drawing from their retirement savings longer than before.
If you retire at 55 and plan to live until 90, that’s 35 years of supplementing your income with your portfolio (and other income channels).
Grim findings from a recent New York Life survey confirm that current retirees’ financial outlooks aren’t all that sunny. Only 31% of adults were “very confident” that their retirement savings would last the rest of their lives.
And it’s not too difficult to understand this fear-origin story. Retirees are plummeted with rising healthcare costs, record inflation, wobbly markets, increased longevity, and more.
This could imply, then, that withdrawing 4% is too much to support such a long life.
Your portfolio always functions in a “worst-case” scenario.
Remember that Bengen was most interested in studying the effect of withdrawing a certain amount of money from a portfolio in a “worst-case” scenario.
He wanted to see the maximum amount someone could take from their portfolio in stressful market conditions and still not run out of money.
Unless you’re the object of unprecedented misfortune, it’s unlikely that your portfolio will be in distress for the entire duration of your retirement. There will probably be a mix of good, bad, and bland years throughout your decades as a retiree, and the 4% rule doesn’t examine your money through that varied lens.
So sometimes, people who adhere to the 4% rule end up spending far less than they safely could. You’ve worked so incredibly hard to make it to retirement; you don’t want to have to scrimp for the next 30+ years.
If You Break The 4% Rule, What Should You Do Instead?
You don’t want to break a rule simply for fun—you’re not a rebellious teenager. So if you don’t use the 4% rule, what’s the alternative?
Use the 4% rule as a starting point, not a roadmap.
Take a look at your nest egg and do a 4% calculation. Is that number more or less than what you expected? No matter the outcome, you can adjust.
Consider your retirement lifestyle expectations, and ask yourself,
- Is there a particular amount of money you want to be able to spend each month/year?
- Do you plan on spending consistently or more sporadically throughout retirement?
- What other sources of income do you have outside of your portfolio? Are there ways you can amplify the “guaranteed income” portion of your retirement plan?
- Do you anticipate being retired for a longer period of time (increased longevity, retiring early, etc.)?
We can help you walk through these questions and more to create a customized withdrawal plan that accounts for retirement risk and works for you and your evolving goals throughout retirement.
If you’re stressing about veering away from this rule, here’s something that will *hopefully* make the transition easier.
The founder, Bill Bengen doesn’t even think the 4% rule always works.
Yep, the creator himself said that 5% is a more accurate representation. But he also says that the rule was never meant to be a “law of nature.” So, the 4% rule isn’t like gravity; it’s not objectively true.
Create A Custom Income Plan That Fits Your Retirement Needs
Adequately supplementing your income for retirement is a tall order, especially in today’s environment. Still, our team is passionate about helping people use their money to live their most ideal and fulfilling lives.
While the 4% rule has been part of the financial dialogue for years, think about it as a recipe; you don’t have to follow it strictly to make a delicious meal, but it’s a nice springboard for ideas.
Remember, you’re not the rule; you’re the exception—full of uniqueness and creativity. Let’s work together to create a tailored investment and income plan that helps your retirement dreams take shape.
Schedule a call with our team to learn more today.
