You’ve probably heard of the 4% rule. For decades it’s been used as a way for investors to figure out how much income they can expect from their portfolios in retirement.
But it may not be as helpful as you’ve been led to believe.
What is the 4% Rule?
It’s a rule of thumb for how much money you can sustainably withdraw from your portfolio in retirement.
In 1994, William Bengen reviewed historical inflation rates and the returns of stocks and bonds. He determined that for a 30-year time horizon, if an investor withdrew 4% of their portfolio at the beginning and then increased it with inflation, they would be unlikely to run out of money. Bengen later referred to this figure as “SAFEMAX” – the maximum percentage an investor could safely withdraw.
In 1998, a study from Trinity University mostly corroborated the findings.
The rule has taken on a life of its own. It is often touted as law, and many aspiring retirees turn to it for unassailable guidance on how much money to withdraw when they retire.
The studies were interesting. But are the findings useful? Should retirees use the 4% rule for retirement planning?
I’d suggest not..
The Problems With The 4% Rule
A Moving Target
Since being published, Bengen has updated his rule numerous times. Most recently, he suggested 5% was fine, and 4.5% would be a worst-case scenario. Then it became 4.7%, and then 4.4%. I’m not sure what it is today, but it’s clear that the rule is malleable, and he changes it based on recent market conditions.
If you’re a long way from retirement, the number will most certainly be different by the time you get there.
Will History Repeat?
The problem with using historical data and projecting it into the future is that it assumes history will repeat. Stock markets are a relatively new invention in the history of humankind. One hundred years is a blip in the grand scheme of things. We don’t have multiple universes of data to draw from, only that produced by us Earthlings.
The future is certainly going to look different from the past, and who knows that that means for markets.
Your Specific Portfolio Matters
The studies examined multiple portfolio allocations, withdrawal rates, and retirement horizons. But the 4% rule comes from a portfolio consisting of 50% Large-Cap US stocks, and 50% US government bonds. It assumed that investors continually rebalanced, meaning they never deviated from this asset mix.
Most investors are unlikely to hold the exact same portfolio for 30 years and remain perfectly balanced at all times.
Even Bengen himself doesn’t advocate for holding the same portfolio over time. He recently suggested investors move half of their portfolio to cash. This is questionable advice, as market timing is a function of luck more than skill. But that’s a topic for another post. Iit’s clear the rule is based on a set of assumptions that even the author doesn’t adhere to.
As for your own risk tolerance and capacity, 50% in stocks might be too high, and it might be too low. The study did review different portfolio allocations, which led to different conclusions. Namely, lower stock allocations led to lower sustainable withdrawal rates.
What About Canadians?
Canadian investors should be holding a globally diversified portfolio.
But the study is based only on US markets, in US dollars. Even if you held 100% of your portfolio in US assets (you shouldn’t), you’re likely going to convert it to Canadian dollars when you spend it. That adds currency risk – the performance of the US dollar will directly impact your portfolio returns, and your safe withdrawal rate. It could benefit you – it could not. Nobody knows.
In a 2017 study, Morningstar Canada looked at historical safe withdrawal rates for 20 different developed countries. Assuming a portfolio of 50% domestic stocks and 50% domestic bonds, the safe withdrawal rate with a 95% success rate varied significantly across countries.
In Japan, it was 0.20%. In the UK, it was 2.80%. The 20-country average, including the US, was only 2.30%.
Historically, the variability of international returns played a significant role in safe withdrawal rates.
This alone should be enough to discard the 4% rule. But if you’re not convinced, read on – I’m not done yet.
You Are Not Average
While averages can be helpful, you are not the average. You are a data point that contributes to the average, meaning your experience will certainly be above or below that average.
In the data, there were periods where a 4% withdrawal rate meant you would have run out of money. Those individuals likely don’t care that their withdrawal was safe ‘on average’.
Your personal expenses are yours, not the average. In retirement, spending will be volatile – nobody spends the same amount of money each year for 30 years. Some years, 4% may be too much, and in some years, too little. People’s spending often declines as they age, and unexpected events can require larger than normal withdrawals.
Your spending should respond to your portfolio performance, not the other way around.
How Long Is Your Retirement?
The study did look at shorter and longer time frames, though the 4% rule was derived from a 30-year time-horizon. With many investors these days aiming for FIRE (Financial Independence, Retire Early), and increasing lifespans, you may be looking at a withdrawal period of more than 30 years.
Granted, it might be less than 30 years. In which case a higher withdrawal rate will be sustainable.
But you won’t know that until it’s too late anyways.
Who Withdraws Their Income Once Per Year?
This likely wouldn’t have had a major impact on the results, but it’s worth pointing out that the study assumed a single withdrawal at the end of the year. Most retirees need income monthly, so the annual withdrawals modeled don’t correlate without how you would actually spend your money.
For example, look at the market drawdown as a result of the Coronavirus in 2020. For the calendar year, the S&P500 finished up over 25%. But from February to March, it dropped more than 30%, and took until August 2020 to recover. Retirees drawing income monthly would have pulled out nearly half of the year’s retirement income while the market was down, leaving less capital in the portfolio to participate in the eventual recovery.
What About Taxes?
There were no taxes considered in the study. But most Canadians will have RRSPs and TFSAs, with the former likely to represent a larger base of retirement assets.
Assuming a 30% marginal tax bracket, a 4% RRSP withdrawal leaves you with 2.8% of the RRSP balance to spend after taxes. On a $1,000,000 portfolio, that’s a $12,000 difference per year –- $1,000 per month. The same investor funding their retirement entirely with TFSAs would have a very different outcome.
For most, it will be a combination of taxable and tax-free retirement income. So, the 4% tells you nothing about how much you can actually spend in retirement, which is the number that really matters.
What You Should Do Instead – Be Flexible
Withdrawing 4% of your portfolio each year, adjusted for inflation, might be too much – it might even be too little.
Flexible retirement spending strategies can help you overcome the shortfalls of the 4% rule. Cutting your spending in response to changes in the markets, inflation, tax regimes etc. provides defense if you get unlucky with inflation or portfolio returns. There are a few well- documented strategies in this arena, which I will write about in a separate post.
If you must use the 4% as a guideline, use it sparsely, and understand its shortcomings. While it’s better to have a target to aim at than no target at all, your target should be yours, based on your own unique circumstances.
None of this is meant to be a knock on William Bengen, or the Trinity Study. And in complete fairness, Bengen didn’t name it the 4% rule – it took on that name later on. It was interesting work, especially at the time, and it contributes to our understanding of retirement planning. My concern is that uneducated investors are adhering to it without understanding its pitfalls.
So, strike the 4% rule from your memory. Or at least, call it the 4% theory.
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