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4% rule for retirement withdrawals written on a chalkboard

Retirement Planning > Saving for Retirement

4% Rule Is Based on Faulty Assumptions, New Paper Argues

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What You Need to Know

  • A new paper argues that the historical record of asset-class performance in the U.S. used to develop the 4% rule likely offers a poor reflection of future returns.
  • A retired couple willing to bear a theoretical 5% ruin probability may withdraw 2.26% per year, according to the researchers.
  • But advisors say rules of thumb shouldn't be relied on for retirement planning.

The 4% withdrawal rule is one of the most broadly cited retirement planning rules of thumb discussed by retirement advisors and their clients.

Defined basically, the rule suggests a given client in retirement should add up all of their investments and simply plan to withdraw 4% of their total wealth during their first year of retirement. The withdrawal amount is then adjusted annually to account for inflation.

In a recent interview with ThinkAdvisor, Wade Pfau, principal and director at McLean Asset Management and RISA LLC, voiced frank concern about the reliability of the rule in the current market environment. Pfau says the very low inflation seen in recent years was the saving grace behind this rule of thumb, because it allowed for a higher sustainable spending rate.

That outlook has changed with substantially higher inflation, such that, according to Pfau and others, it will be very difficult for people to actually follow this rule without depleting their portfolios late in retirement.

Now, a new paper published by researchers at the Universities of Arizona and Missouri offers up a new “safe withdrawal” figure, and it is substantially lower than the traditional 4%.

The authors of the paper include Aizhan Anarkulova, Scott Cederburg and Richard Sias, all of the University of Arizona, and Michael O’Doherty, of the University of Missouri-Columbia. According to the quartet, a 65-year-old couple willing to bear a 5% chance of financial ruin over a 30-year retirement period can withdraw just 2.26% per year.

Faulty Assumptions Behind 4% Withdrawals

As the researchers point out, the 4% rule originates from a 1994 analysis published by William Bengen, whose works suggests that a retirement strategy with 50% in U.S. stocks and 50% in government bonds would have survived each 30-year period in the U.S. historical record from 1926 to 1991 — so long as the asset owner withdrawals no more than 4% per annum during that period.

“The ‘safe’ 4% spending rule is ubiquitous and recommended by financial advisors, brokerages, mutual fund companies, retirement groups and the popular press,” the researchers note.

While exceedingly popular, the researchers suggest, the 4% rule is a leading example of the divergence between finance theory and practice, especially in its lack of consideration of income insurance opportunities purchased via annuities.

“Normative portfolio choice models prescribe full or considerable annuitization of assets at the onset of retirement to address the risk of households outliving their wealth,” the analysis states. “In practice, however, few retirees purchase life annuities, and annuitization has, if anything, declined in popularity in recent years.”

The quartet posits that academic explanations for the “annuitization puzzle” include adverse selection issues, bequest motives, health risks and behavioral factors. Thus, the researchers explain, there is debate regarding the extent to which retirees should annuitize versus self-fund retirement.

Theory aside, current retirement spending practices demonstrate a revealed preference for spending rules over annuitization.

“Retirees must balance the desire to make larger withdrawals to maintain a reasonable standard of living against two risks that can deplete their wealth, which are longevity risk and return risk,” the paper states.

According to the researchers, modeling the impact of longevity risk on withdrawal rules is straightforward for a random retiree from the population, given the depth of actuarial information available on mortality risk. Modeling return risk is a more difficult problem.

“Quantifying the likelihood and severity of left-tail outcomes is particularly important, as poor market performance during retirement can be catastrophic,” they warn.

Sober Spending Conclusions

In their paper, the researchers seek to highlight a few critical facts about the period of market returns used in the original 4% withdrawal analysis. First, evidence suggests that the historical U.S. asset market performance during this period likely exceeded reasonable forward-looking expectations when viewed from a global perspective.

“The experience of U.S. investors [between 1926 and 1991] does not mirror that of investors in many other developed markets,” the paper states. “For example, although long-horizon equity market losses are rare or nonexistent in the U.S., Japan’s stock market suffered a nominal return of -9% over the recent 30-year period from 1990 to 2019.”

In short, the analysis posits, the historical record of asset-class performance in the U.S. used to develop the 4% rule likely offers a poor reflection of the forward-looking return distribution.

The new analysis seeks to address these concerns by using a comprehensive dataset of real returns for domestic equity, international equity, government bonds and government bills in developed economies. The data cover approximately 2,500 total years of asset-class returns in 38 developed countries over the period from 1890 to 2019.

“As such, our evaluation of the 4% rule and its alternatives better reflects the ex ante uncertainty faced by current and future retirees,” the researchers state.

Ultimately, the researchers find the 4% rule proves “woefully inadequate” for current retirees. Specifically, a retired couple faces a 17.4% probability of financial ruin — i.e., depletion of financial wealth prior to death — using the 4% rule.

“Given the poor performance of the 4% rule, we explore alternative constant real withdrawal policies,” the paper states. “Our findings suggest that most retirees (i.e., retirees with relatively modest levels of wealth) cannot achieve a reasonable standard of living while maintaining a very low ruin probability.”

To achieve a 1% ruin probability, for example, retirees must adopt a withdrawal rate of just 0.80%, or just $8,000 of withdrawals per year for $1 million in savings. When they attempt to balance the desires to achieve a higher standard of living and to avoid financial ruin, the researchers find that a retired couple willing to bear a 5% ruin probability may withdraw 2.26% per year.

This value is considerably lower than those proposed in prior studies, and it is just over half of the 4.22% rate implied by the post-1925 U.S. data.

Advisor Interpretations

Asked to interpret these numbers from the perspective of a financial advisor working with retired clients, Kelly Wright, director of financial planning at Verdence Capital Advisors, says they are eye-opening. However, he wonders whether they are informative from a practical perspective.

“Given the late-September dividend rate of the S&P 500 was about 1.7%, and the long-term rate is higher, a ‘safe’ withdrawal rate of 1.5% to 2.5% seems somewhat conservative,” Wright says. “Although the dividend yield rate of the S&P 500 is about 1.5% this decade so far, that means that capital gains of only 2.5% allows for a total return of 4%.”

Harman Johal, a U.S. Bank private wealth management market leader, says the determination of a given client’s withdrawal percentage from a retirement account must consider many factors.

“A static rate of withdrawal may either deplete your retirement account too soon or may leave more assets than you intended to,” he points out. “When you are determining a spending goal from your retirement accounts, a financial plan can take into consideration factors such as your current and future portfolio allocations, any big expenses you foresee, health care related costs and appropriate inflation numbers, among other factors.”

Johal encourages clients to update their financial plan annually so that they can adjust their withdrawal rate if there’s excess volatility in the markets or other emerging challenges.

“Our advice to clients is based on a planning-based approach,” he emphasizes. “We take a deep dive to understand clients’ goals and objectives to create a financial plan. We are able to help clients identify if they need to wait a few years to retire or withdraw less than they expected to, so they don’t run out of money in their later retirement years.”

Jay Zigmont, founder and childfree wealth specialist at Childfree Wealth, emphasizes that no two clients have the same outlook regarding the future, meaning that universal rules of thumb, whether they pertain to spending or saving, are not necessarily useful in practice.

“Many of the clients who I work with are not planning on a complete exit from the workforce such that they will need to survive on portfolio withdrawals alone for 30 years,” Zigmont notes. “The evolving definition of retirement is an important consideration when creating an income plan.”


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