You may have heard of the “4 percent rule” or one of a variety of its variants. Whether it’s the 4-percent rule, the 4.5 percent rule, the 3.14159 percent rule, or any other version of this legendary piece of retirement planning wisdom, the basic premise is the same. This rule is supposed tell you how much you can safely withdraw from your savings and investment portfolio in retirement without risking running out of money before you run out of life.
The problem with the 4-percent rule, and the reason that I am writing about it here, is that it’s unreliable at best, and dangerous, at worst. I have been hearing about the rule for more than 20 years, now, and it’s clear that far too many investors take the rule far too seriously as a basis for their financial planning.
Here’s what the rule, in its usual incarnation, is understood to say: You may start by withdrawing up to 4 percent of your portfolio’s starting balance in the first year of retirement and then, adjusting this amount upward for inflation each year, continue withdrawing this amount each year for as long as you live, without having to worry about running short. So, for example, if on the first day of your retirement, your Thrift Savings Plan account balance is $300,000, during the coming year, you may withdraw 4 percent of $300,000, or $12,000, from the account during the following 12 months. During the second year of retirement you may again withdraw $12,000 from the account, plus you may withdraw enough to compensate for the change in the cost of living that has occurred since you retired. This process is repeated every year. Once the amount of the first annual withdrawal allowance is computed, the account’s balance is no longer considered in determining future allowances. The rule tells you that you can go along taking an ever-increasing series of withdrawals without concern.
Before I dismantle this rule’s proposal, I’ll point out that while the rule seems essentially concerned with avoiding the risk of running out of money, it is really dealing with the concern that you might not withdraw as much as you could, safely, from your resources. There are two risks to consider when planning for retirement: The risk of spending too much and the risk of spending too little. While the risk over-spending can reasonably be considered the more important of the two, both of these risks are important and any approach to determining your retirement standard of living should be evaluated in light of its ability to deal with both of them.
There are so many problems with this rule, and rules like it, that it’s hard to know where to start a constructive critique. I could discuss the origin of the rule and explain its limitations, how it is being misapplied, and why it is unreliable from analytical and practical perspectives, but this would take far more space than I have here. Fortunately, this isn’t necessary to make my point. The fact is that there is no withdrawal scheme that does what the 4-percent rule is usually assumed to do: avoid the risk of over-spending; avoid the risk of under-spending; produce a predictable stream of income, and apply to every retiree.
It’s simply not possible to do all four of these things at the same time. Even if you limit the application of such a rule to retirees with similar time horizons — say 20 or 30 years — there can be no such rule. If two retirees have exactly the same time horizon and start with the same account balance, is it safe to assume that both can safely withdraw at the same rate? What about accounting for differences in how they will manage their accounts over that time horizon? Is the maximum safe withdrawal rate the same for an all G-Fund account as it is for an account invested entirely in the S-Fund? Of course not!
There is a unique “rule” for every retiree and there is no single rule that applies to every retiree. It is possible, with the right amount of understanding and effort, to determine that rule. Blindly following the 4-percent rule will lead some investors to over-spend their way to ruin while it leads others to under-spend their way to remorse. Either way, it is unsafe and should be ignored, or at least followed with a clear understanding of the risks involved.