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John Manganaro

Retirement Planning > Spending in Retirement > Income Planning

It’s Time to Bury the 4% Rule for Good

By John Manganaro

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What You Need to Know

  • The rule, based on a 1994 paper by Bill Bengen, is still often touted as a safe rule of thumb for retirement spending.
  • Higher inflation, lower projected market returns and longer life spans mean the rule is no longer reliable.
  • Retirement researchers have made major strides in recent years on outlining new, flexible spending strategies.
This is the second in a new series of columns about Social Security and retirement income planning. 

The problem with so-called “safe” fixed withdrawal rules for retirement spending, including the famous 4% rule, is that the underlying assumptions are woefully out of date, and top planning experts say the time has come to consign these rigid strategies to the dustbin of history. 

In their stead, fiinancial advisors can lean on modern planning techniques and technologies that deliver a far more flexible and responsive approach to retirement income, including the increasingly popular guardrails framework. 

The simple truth is that people today tend to live much longer in retirement than they did 30 years ago when the 4% rule was first tabulated, and empirical data shows retirement spending fluctuates a lot based on people’s real-world needs. Still, the 4% rule remains ubiquitous in the popular media, and it is even recommended by some financial advisors.

Unfortunately, such advisors may be steering their clients toward the dreaded retirement income death spiral, which is the inevitable result of at-risk clients failing to carefully monitor the effect of annual spending or market drops on their overall financial plan. Advisors who use the 4% rule might also be causing wealthy clients to significantly underspend when there are no big legacy goals to fund.

By embracing the concept of retirement income guardrails and dynamic spending frameworks — potentially to be complemented by the shrewd addition of annuities to the portfolio — advisors can help their clients spend in a truly safe manner while meeting their lifestyle goals.

Why the 4% Rule Doesn’t Work Anymore

The 4% 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.

The approach is attractive for its simplicity and its alleged safety, but as Wade Pfau, principal and director at McLean Asset Management and RISA LLC, recently told me, there is good reason to have concerns about the reliability of the rule in the current market environment.

Echoing the insights of researchers and planning experts including PGIM’s David Blanchett and Michael Finke at The American College of Financial Services, Pfau says the very low inflation rate seen in recent years was the artificial saving grace behind this rule of thumb. The outlook has now changed with substantially higher inflation, longer client lifespans and lower long-term capital market return assumptions. 

As Finke emphasizes, the 4% rule originates from a single 1994 analysis published by William Bengen, whose work suggested 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 with inflation adjusted annual withdrawals starting at about 4%.

Since that time, however, there have been some big changes in the marketplace, Finke says. Simply put, the United States enjoyed a uniquely strong period for returns in the 20th century that was used as the basis for Bengen’s research, and it may no longer be valid going forward.

There’s also the fact that the U.S. is seeing rapid longevity increases that go beyond the assumptions baked into the 4% withdrawal rule. This is especially true for the top 10% of income earners, Finke notes, who tend to be advisors’ best clients.  

“We have seen six additional years of longevity for men in just the last two decades,” Finke says. “For a healthy couple retiring at 65 today, some 50% of them will see at least one spouse live beyond 95 — the maximum age considered in the original 4% rule research.”

Are Income Guardrails the Answer?

Among the financial planning luminaries consistently advocating for a better income planning approach is Jamie Hopkins of Bryn Mawr Trust. According to Hopkins and others, a better strategy is to constantly monitor and regularly adjust spending (up or down) during retirement.

This is often called a guardrails approach.

Advisors can use modern planning tools to create a more sustainable retirement spending plan by making adjustments over time and keeping their clients within the guardrails, Hopkins proposes. And guardrails aren’t just about safety. They are also about taking advantage of any abundance a client might have.

When one looks beyond the simple binary success or failure framework that underpins the 4% rule and other Monte Carlo-based strategies, one starts to see that small adjustments can make a big difference to the projected outcomes, Hopkins explains.

A client facing a tricky retirement outlook could work six months to a year longer, for example, and comfortably fix a failing plan. Perhaps they could factor in more tax-efficient withdrawals and the opportunity to make Roth conversions, or they could draw Social Security later or purchase an annuity to add a baseline of safety to the plan.

Combining these strategies with the guardrails approach will result in superior outcomes for many clients, Hopkins and the others conclude, and the best part is that advisors can turn to a rapidly growing stable of tools and solutions to help them with this work.

For his part, Hopkins urges advisors to play around with the tools that are now available online from the Income Lab, but there is a wealth of online resources to consider.

Putting Guardrails in Practice

Perhaps the clearest example of how guardrails can work was offered up in a recent interview with Derek Tharp. To help demonstrate how an advisor and client might use a dynamic risk-based spending framework, Tharp gave the example of a client starting with a target initial Monte Carlo probability of success of 90%.

If their portfolio experiences strong growth early in retirement and the recalculated success probability reaches 99%, the client could comfortably increase spending to a level that would again leave them with a 90% forward-looking probability of success.

If they experienced tough markets early in retirement or ended up spending more than anticipated and the recalculated probability of success fell to 70%, the client could then decrease spending to a level that would give them a 90% probability of success.

Tharp gave an example of a client who plans to start their retirement spending $9,000 a month based on a $1 million portfolio and other guaranteed income sources such as Social Security. Using this approach, this client could increase spending to $9,500 per month if the portfolio grows to $1.1 million, while they would need to decrease spending to $8,500 per month if the portfolio declines to $700,000.

According to Tharp, the risk-based guardrails approach offers a number of levers to pull with respect to adjusting the plan on a regular basis. He says the four main levers are the initial withdrawal rate, the potential adjustment thresholds, an optional spending ceiling and an optional spending floor.

While such planning conversations are likely to be more complex than just recommending a fixed withdrawal amount, Tharp says clients appreciate the fact that the advisor in this planning scenario can give them exact dollar figures that speak to when spending changes would have to happen and how large they would have to be. This is much different than what a traditional Monte Carlo simulation provides, he notes.

John Manganaro

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