What is the 4% rule?Many would summarize the 4% rule as follows:
You can safely withdraw 4% of your retirement savings each year in retirement without risk of running out of money.This statement is not only vague; it's inaccurate. It doesn't say anything about how the retirement savings is invested, or how to cope with inflation, or just how much risk there is of running out of money.
The 4% rule was first developed in a paper by William Bengen. Here is the 4% rule from the horse's mouth:
For a client just beginning retirement, determine first the "safe" withdrawal rate. … For a client of age 60–65, this will usually be about 4 percent. The withdrawal dollar amount for the first year (calculated as the withdrawal percentage times the starting value of the portfolio), will be adjusted up or down for inflation every succeeding year. After the first year, the withdrawal rate is no longer used for computing the amount withdrawn; that will be computed instead from last year's withdrawal, plus an inflation factor.So this is not a withdrawal rate of 4% per year. It's a withdrawal rate of 4% in the first year, adjusted for inflation thereafter.
What is Bengen's advice for asset allocation?
Despite advice you may have heard to the contrary, the historical record supports an allocation of between 50-percent and 75-percent stocks as the best starting allocation for a client. For most clients, it can be maintained throughout retirement, or until their investing goals change. Stock allocations below 50 percent and above 75 percent are counterproductive.And just how safe is this strategy? Bengen back-tests the strategy using market performance and inflation numbers between 1926 and 1992. With a 50/50 split between stocks and bonds, Bengen concludes:
Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe. In no past case has it caused a portfolio to be exhausted before 33 years, and in most cases it will lead to portfolio lives of 50 years or longer.Of course, the merits of conclusions based on back-testing can be questionable, but at least we know exactly where the 4% rule comes from.
Does this make sense?The main problem I have with this advice is that it breaks what I consider a very reasonable soundness test: two people in identical situations should be given the same advice. However, consider Allan and Barney, both 65 years old with $1M in 50/50 stocks and bonds, and both with the same actuarial risks (both married, non-smokers, living in the same part of the country, etc.). Suppose inflation is 3%.
Allan is retiring in March 2009. Barney retired in March 2008. At the time, Barney's nest egg was $1.3M. He dutifully withdrew $52k for the year.
What advice do we give these two men in March 2009?
We advise Allan to withdraw $40,000 (which is 4% of his portfolio), but we advise Barney to withdraw $53,500 (the previous withdrawal adjusted for inflation) despite being in precisely the same financial situation. To me, this is inherently irrational, but it's hard to offer better advice to poor Barney, who would be understandably upset at the prospect of decreasing his annual income by 20%.
Can we do better?A subsequent paper by Scott, Sharpe, and Watson addresses the question of whether Bengen's strategy is the most cost-efficient way to ensure you get a reliable cash flow during retirement. They identify two sources of inefficiency: one is a relatively minor one that they address using option trading; I find that one fairly uninteresting because it only amounts to 2-4% of your savings, and recouping that requires some fairly esoteric financial maneuvering. However, the more interesting inefficiency is fairly straightforward and accounts for 10-20% of the portfolio's value.
To understand this inefficiency, first consider that if you kept your nest egg as cash under your mattress, you could safely withdraw 4% per year for 25 years with zero risk of running out of money during that time. Suddenly, investing in a mix of stocks and bonds to achieve a probable 33 years of withdrawals is not so impressive anymore.
Of course, your mattress doesn't compensate you for inflation, but this is easily fixed using inflation-protected government bonds. With a typical real return of 2%, Scott et al argue that the retiree could finance 30 years of guaranteed inflation-adjusted withdrawals for the price of just 22.4 years. This amounts to a withdrawal rate of 1/22.4 = 4.46%!
What gives? How could stogy old inflation-protected bonds offer a withdrawal rate 11% higher than that of the stocks-and-bonds portfolio?
The answer is that choosing the bonds over the market portfolio gives up both the potential upside and downside of the market. Because the market generally increases over time, the upside over a 30-year time frame is much higher than the downside risk, and the market values this at approximately 11% of the withdrawals per year.
The bond investor has also accepted the certainty that his money will be gone after year 30. The stocks-and-bonds investor likely still has money left to continue his withdrawals indefinitely, and extremely likely still has enough at least for years 31-33.
This is what the inflation-protected bond investor has given up in exchange for a 11% higher withdrawal rate and zero risk.