If you have spent any time researching retirement planning online, you have heard of the 4% rule. If you haven’t heard of it, the 4% rule suggests that if you spend 4% of your assets in your initial year of retirement, and then adjust for inflation each year going forward, you will be unlikely to run out of money. To put some numbers to it, if you wanted to retire and spend $40,000 per year, adjusted for inflation, from your portfolio, you would need to retire with one million dollars to adhere to the four percent rule. This rule is alternatively described as the requirement to have 25 years worth of spending in your portfolio to afford retirement. 1/25 equals 4% – it’s the same rule. While it is simple and elegant, the 4% rule is probably not the best way to plan for retirement, especially if you plan on retiring early. I’m Ben Felix, Associate Portfolio Manager at PWL Capital. In this episode of Common Sense Investing, I’m going to tell you why the 4% rule is not a rule to live by.
The 4% rule originated in William Bengen’s October 1994 study, published in the Journal of Financial Planning. Bengen was a financial planner. He wanted to find a realistic safe withdrawal rate to recommend to his retired clients. Bengan’s breakthrough in determining a safe withdrawal rate came from modelling spending over 30-year periods in US market history rather than the common practice of simply using average historical returns. Using data for a hypothetical portfolio consisting of 50% S&P 500 index and 50% intermediate-term US government bonds he looked at rolling 30-year periods starting in 1926, ending with 1992. So, 1926 – 1955, followed by 1927 – 1956 etc., ending with 1963 – 1992. The maximum safe withdrawal rate in the worst 30-year period ended up being just over 4%. From this simple but innovative analysis, the 4% rule was born. More recently Bengen has adjusted his spending rule to 4.5% based on the inclusion of small cap stocks in the hypothetical historical portfolio.
While the 4% (and the 4.5% rule) may have basis in historical US data, there are substantial problems with these rules in general, and specifically in the case of a retirement period longer than 30 years. In his 2017 book How Much Can I Spend in Retirement, Wade Pfau, Ph.D, CFA, looked at 30-year safe withdrawal rates in both US and non-US markets using the Dimson-Marsh-Staunton Global Returns Dataset, and assuming a portfolio of 50% stocks and 50% bills. He found that the US at 3.9%, Canada at 4.0%, New Zealand at 3.8%, and Denmark at 3.7% were the only countries in the dataset that would have historically supported something close to the 4% rule. The aggregate global portfolio of stocks and bills had a much lower 30-year safe withdrawal rate of 3.5%. Considering returns other that US historical returns is important, but, in my opinion, one of the most important assumptions to be aware of in the 4% rule is the 30-year retirement period used by Bengen. People are living longer, and many of the bloggers citing the 4% rule are focused on FIRE, financial independence retire early.
In Bengen’s study the 4% rule with a 50% stock 50% bond portfolio was shown to have a 0% chance of failure over 30-year historical periods in the US. That chance of failure increases to around 15% over 40-year periods, and closer to 30% over 50-year periods. FIRE likely means a retirement period longer than 30 years. Modelling longer time periods using historical sampling becomes problematic because we have data for a limited number of historical 50-year periods.
One way to address this issue is with Monte Carlo simulation. Monte Carlo is a technique where an unlimited number of sample data sets can be simulated to model uncertainty without relying on historical periods. Even with Monte Carlo simulation, there is an obvious risk to using historical data to build expectations about the future. The world today is different than it was in the past. Interest rates are low, and stock prices are high. While it may be reasonable to expect relative outcomes to persist, such as stocks outperforming bonds, small stocks outperforming large stocks, and value stocks outperforming growth stocks, the magnitude of future returns are unknown and unknowable. To address this for financial planning, PWL Capital uses a combination of equilibrium cost of capital and current market conditions to build an estimate for expected future returns for use in financial planning. This process is outlined in the 2016 paper Great Expectations.
Using the December 2017 PWL Capital expected returns for a 50% stock 50% bond portfolio we are able to model the safe withdrawal rate for varying durations of retirement using Monte Carlo simulation. We will assume that a 95% success rate over 1,000 trials is sufficient to be called a safe withdrawal rate. For a 30-year retirement period, our Monte Carlo simulation gives us a 3.5% safe withdrawal rate. Pretty close to the original 4% rule, and spot on with Wade Pfau’s global revision of Bengen’s analysis. Now let’s say a 40-year old wants to retire today and assume life until age 95. That’s a 55-year retirement period. The safe withdrawal rate? 2.2%. I think that this is such an important message. The 4% rule falls apart over longer retirement periods. So far we have talked about spending a consistent inflation adjusted amount each year in retirement. One way to increase the amount that you can spend overall is allowing for variable spending. In general this means spending more when markets are good, and spending less when markets are bad. The result is more spending overall with a lower probability of running out of money. The catch is that you have to live with a variable income or have the ability to generate additional income from, say, working, to fill in the gaps when markets are not doing well.
We also need to talk about fees. Fees reduce returns. Fees may be negligible if you are using low-cost ETFs, but they become extremely important if you are using high-fee mutual funds, or if you are paying for financial advice. The safe withdrawal rate in the worst 30-year period in the US drops to 3.56% with a 1% fee, making the 4% rule the more like the 3.5% rule after a 1% fee.
Adding a 1% fee to the Monte Carlo simulation reduces the safe withdrawal rates by around 0.50% on average. In both cases this is a meaningful reduction in spending. Of course, fees need to be considered alongside the value being received in exchange for the fee. This value should be heavily tied to behavioural coaching and financial decision making. There have been two well-known attempts to quantify the value of financial advice, one by Vanguard and one by Morningstar. Vanguard estimated that between building a customized investment plan, minimizing risks and tax impacts, and behavioural coaching, good financial advice can add an average of 3% per year to returns. Morningstar looked at withdrawal strategies, asset allocation, tax efficiency, liability relative optimization, annuity allocation, and timing of social security (CPP in Canada), to arrive at a value-add of 2.34% per year.
PWL Capital’s Raymond Kerzerho has also written on this topic, finding an estimated value-add of just over 3% per year. Based on these analyses, one could argue that paying 1% for good financial advice could even increase your safe withdrawal rate. I would not go that far, but the point is that while fees are a consideration, they may be worthwhile in exchange for good advice.
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