In this series, we provide our readers with two distinct perspectives on the same topic — one from an academic, the other from a practicing financial advisor.
QUESTION: Is the 4% rule dead?
THE ADVISOR — JOE ELSASSER, CFP, PRESIDENT, COVISUM:
The 4% rule is not a rule at all, unless you mean rule of thumb. There have been other “rules” based on similar ideas. Famed portfolio manager Peter Lynch of the Fidelity Magellan Fund famously published a 7% “rule” in his 1995 article entitled “Fear of Crashing.” His argument was that stocks dramatically outperform bonds over time, so an all-stock portfolio, based on stocks with an average dividend yield of 3% and 8% return from capital gains would grow from $100,000 to almost $350,000 after 20 years, and would even survive a 25% crash, with an ending value of approximately $185,000.
Lynch’s argument, which represented much of the feeling of the time, was challenged by Bill Bengen, who is now known as the father of the 4% rule. Bengen changed the discussion by arguing first that a 20-year retirement period was not enough, extending his analysis to 30 years. Bengen used rolling 30-year periods, actual market returns and actual inflation to identify 4% as a safe withdrawal rate. His results showed that if you began drawing on a portfolio on the worst possible day in history and continue withdrawing an inflation-adjusted amount every year for 30 years, 4% was the highest amount you could sustain while still having money left at the end of the 30-year period. He called this withdrawal rate the Safemax.
In short, Bengen’s process for arriving at 4% was considerably more robust and used better assumptions than Lynch’s. As a result, it yielded a much lower safe withdrawal rate. Funny enough, Lynch’s rule was pretty close to a 4% rule, but he assumed that a 3% and growing dividend would always be present.
Now, the 4% is being challenged on all sides, in roughly the same way Bengen challenged Lynch and the prevailing “wisdom” of the day. Bengen chose a 30-year period, but life expectancy has been consistently increasing. Bengen used U.S. stock returns. Is that a fair assumption? Is it likely that the next 30 or 40 years of U.S. returns will parallel our economic history in which stocks climbed from 22% of the world’s total market capitalization to 54%? 1
Wade Pfau evaluated the 4% rule using a global dataset and found that not only is the United States’ experience not representative of the experience of other countries, but it would be dangerous to assume that the rule will work in the future. [PDF]
The practical aspects of implementing a 4% rule become even more tenuous. The 4% rule is a gross number and doesn’t account for fees or taxes, both of which take a significant bite out of most retirees’ portfolios. Also, few retirees actually follow a smooth withdrawal pattern in which a level real amount is withdrawn from the portfolio annually. They buy cars, go on trips early in retirement, pay for college for a grandchild. They may have some income sources like Social Security that don’t start until a little later in retirement, necessitating a higher withdrawal amount early in retirement. These issues are often referred to as the “lumpy” cash flow problem. Whenever there are spikes in an income need, the spikes represent additional risks, particularly if they occur early in retirement.