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Robert Bloink and William H. Byrnes

Retirement Planning > Spending in Retirement

Here's What's Wrong With the 4% Rule

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What You Need to Know

  • The 4% rule seems like a simple solution for retirement spending, but there are pitfalls.
  • The best approach is one that adjusts for actual market returns and real-life inflation rates.
  • For investors who prefer a formulaic approach, a better alternative to the 4% rule is to use the IRS' RMD table.

Clients save for retirement over the course of their working careers. 

While retirement income planning can be complicated given the variety of available options, it’s typically easy to advise clients about how much they should be saving. Most clients should be advised to contribute the maximum amount they can afford to tax-preferred retirement accounts. 

The advisory picture becomes much more complex when it comes time to start drawing from those accounts. Once required minimum distributions are satisfied, clients often wonder how much they can safely withdraw to minimize the risk of running out of money during retirement. 

The “4% rule” is an often-cited strategy. Most retirees who rely primarily on retirement accounts for income during retirement will have difficulty adhering strictly to the rule’s assumptions. Although many clients like the formulaic approach of the 4% rule, it’s critical that advisors explain the fine print — and the risks associated with adhering strictly to the 4% rule during retirement.

Understanding the 4% Rule

The premise behind the 4% rule is simple. During the first year of retirement, clients withdraw 4% of their retirement account balance. For 30 years thereafter, that withdrawal rate is then adjusted by the rate of inflation as measured by the Consumer Price Index.

William Bengen, a financial advisor, published a paper in 1994 outlining the benefits of the 4% rule. His results were based on a study of stock and bond returns over a 50-year period, from 1926 to 1976, and a portfolio that consisted of 60% stocks and 40% bonds. Basically, the portfolio he used was designed to track the S&P 500.

The primary appeal of the 4% rule is that a client doesn’t have to engage in complex evaluations year after year during retirement. 

Potential Pitfalls

There are, of course, many pitfalls that clients should understand. First of all, the 4% rule is based on a 30-year retirement. Depending on the client’s age and life expectancy, a 30-year planning horizon may not be warranted. 

The 4% rule also fails to account for emergency situations. It assumes that the client’s spending will remain constant year after year, which isn’t always realistic — and, as we’ve all seen in the past few years, inflation can be unpredictable. The client’s spending could significantly outpace the rate of inflation. 

The rule assumes that the client pays no investment fees and doesn’t account for taxes (in other words, any investment fees and taxes are paid with the money that is withdrawn). 

The most dramatic pitfall may be that the 4% rule fails to account for the portfolio’s actual performance year after year. Because the clients don’t consider their actual investment earnings during retirement, it’s possible that they could end up withdrawing much more, or much less, than they safely should have. Clients, of course, have different risk tolerances — meaning that the 60/40 split assumed by the 4% rule may not be preferential.

The advisor behind the 4% rule also assumed that the rule must result in a 100% success rate. However, different withdrawal approaches that account for real-life investment performance can yield similarly strong results with less risk that the client will leave money on the table. 

Alternative Approaches

Many clients mistakenly believe that adopting a “safe” withdrawal rate is required to prevent them from running out of money during retirement. With quality financial guidance, clients can base annual withdrawals on actual market returns and real-life inflation impacts.

Clients who prefer a formulaic approach may be better served by relying on the Internal Revenue Service’s actual RMD tables. Even if clients have yet to reach RMD age, they can use the IRS’ tables and base annual withdrawals on their own account balance and life expectancy. In many ways, the RMD approach is much more realistic and reasonable than the 4% rule because it’s based on a client’s actual account balance year after year. 

Clients who rely on the RMD approach should also be advised on the potential benefits of delaying Social Security to account for the funds withdrawn from retirement accounts during the early years of retirement. 

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