A Canadian's random thoughts on personal finance

Dec 11, 2009

Is the 4% rule good advice?

If you've spent any time reading personal finance blogs, you must have come across the "4% rule". It is quoted with impressive regularity, yet it is rarely explained, and even more rarely questioned.

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 After the first year, the withdrawal rate is no longer used for computing the amount withdrawn; that will be computed instead from last year's withdrawal, plus an inflation factor.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.

So what should we do?

The best course of action may be a combination of the two. Buy inflation-protected bonds to fund 30 years of living expenses based on your budget, and use the remainder of your portfolio to invest in stocks and bonds, which could improve your standard of living, fund your expenses after 30 years, and leave an inheritance for your family.


Michael James said...

I always preferred to think of the 4% rule as meaning that you can spend 4% of the current value of your portfolio each year, whatever that value may have changed to. So, this may mean having lean years if your investments lose money.

This approach avoids the logical inconsistency you explained, but it can also lead to some leaner years. I'm content to cut back spending a little when consumer items become expensive relative to my stock portfolio (i.e., when stock prices are down). I realize that many people have fixed expenses that may make cutting back a little difficult, but it works well for me.

Patrick said...

Hi Michael,

Without crunching the numbers, I'll venture to guess that if you're willing to endure lean years, you could safely withdraw more than 4% per year.

Bengen's paper presents his 4% rule as an alternative to what advisers were (apparently) doing before his analysis: they were advising their clients to withdraw 5-6% of their portfolio based on the average real return of the market. He makes the point that this advice only works as long as market returns are close to the average. Once you consider the effect of market crashes or high inflation, continuing to withdraw the same amount eventually proves disastrous.

However, if you're willing to decrease your withdrawals during the lean years, it is (trivially) valid to withdraw the market's average real return. If the market enters a very long period of under-performance, you might end up with a dramatically reduced income, but your savings can never hit zero with this approach (for whatever that's worth).

Michael James said...

My thinking for having to endure lean years is that if I stick to my version of the 4% rule, my withdrawals should increase with time (in real terms) and so future "lean" years might actually be better than my initial years, which shouldn't be too hard to take. If the lean years are at the beginning, then cutting down spending is necessary because this is precisely the scenario that can lead to exhausting a portfolio early when using the standard 4% rule.

Patrick said...

Hi Michael,

In that scheme, you're effectively giving yourself a raise each year that exceeds a cost-of-living allowance. Whether that's a good idea depends on which years of your retirement you want to enjoy the most. :-)

Patrick said...

I hasten to add that I don't disagree with your scheme. Withdrawing less than the expected real return on your portfolio is a good way to manage the risk of a bear market. If you spend all your gains and keep the real value of your portfolio constant, that risk will always be present for the rest of your life. If you're a bit more conservative at the start and build up a "war chest" then you can withstand a later bear market without reducing your withdrawal rate.

CanadianInvestor said...

Good post to an important and revealing though difficult article.

My caveats to their conclusion. Most people don't only have the income objective so the possibility of a surplus is not bad - it is the legacy. But the article tells us the cost of taking the chance of providing the legacy. So the surplus isn't necessarily waste.

It is also not trivial to fund only for 30 years and to live 35. The 4% rule more or less ensures a perpetual portfolio. To sustain perpetual returns on real return bonds yielding 2%, the withdrawal rate would have to be no more than that.

I did love footnote 13 on page 13 where they say that the market will not reward sequence of returns risk, which is one of the main risks retirees with any amount of "stock/bond portfolio" must face.

Despite the above, the point is well taken that retirement income design must be matched with spending. The principle of matching assets with liabilities still applies.

Nice blog, Patrick, I'll be visiting again and adding this to my blog list.

Patrick said...

@CanadianInvestor: Thanks! I've read your blog with interest in the past too. You may be disappointed with the frequency of my posts though; this blog is a pure hobby for me.

CanadianInvestor said...

Hi again,
Was thinking about your Allan and Barney comment. Bengen, one of the main originators of this rule, is much more nuanced about his advice. He says 4% (actually it is 4.15% in his book) is a suggestion of what has worked in the past not a an absolute prescription. Therefore,
- every year is the first year of the rest of your life and if you want to change after one year given a big decline it may be wise to reduce risk. In fact, he says a current withdrawal rate above 6.8% is a danger sign even if the original rate was 4%.
- the second retiree can retrospectively adopt the same withdrawal rate as the first guy and still be safe i.e. it will work for the first guy so it will foir the second guy too
- the first guy will be living with a higher risk of expiry if he has the same 30 year horizon as the second guy - he started a year earlier so the 30 year guarantee only has 29 years left
- Bengen goes on to show how the safe withdrawal rate goes up progressively as time horizon drops.

Patrick said...

@CanadianInvestor: Thanks for the additional thought-provoking info. I based my post solely on Bengen's original paper, so I'm interested to learn of the refined advice from his book.

From what you've said, it sounds a bit like the differences can be summarized as: "use the 4% rule, then mix in a little common sense". While undoubtedly sensible (by definition!), it's hard to evaluate advice described in such a vague form. Is it possible to tell from Bengen's book what advice he would give to Allan and Barney?

One thing that does worry me is your second point. I do think Allan and Barney are in identical circumstances, but that in itself does not support the conclusion that Allan would be safe to adopt Barney's higher withdrawal rate. There's a symmetry here, and I don't see how one can confidently reject the notion that it is Barney who must adopt Allan's lower withdrawal rate!