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Distribution is Different: What You Might Not Know About the 4% Rule

Distribution is Different: What You Might Not Know About the 4% Rule

November 15, 2023

Defining and understanding your retirement "strategy" 

It's typical for us to ask our potential clients what their retirement strategy is, before they've begun work with us. Our goal in asking is not to determine how much they have saved in a particular vehicle, like a 401k, but rather to gauge to what extent they've considered a very important question: when you reach the phase where your assets must fuel your future income, how exactly will you get funds off of your balance sheet and into your spending accounts?  

How do you think about the impact of timing, risk, markets, and taxes when you look ahead to the distribution phase? 

When people have considered this (which is less often than you may have guessed), the best-known plan is usually something like this: build up a nest egg, invest more conservatively, and live off of the interest. 


The 4% Rule 

And within that strategic category, a commonly cited idea is that of "The 4% Rule." The 4% withdrawal rule is a common guideline used in retirement planning that suggests that retirees can withdraw 4% of their retirement savings annually during retirement. The rule was first introduced in a 1994 study by financial planner William Bengen, and has since become a widely accepted rule of thumb for retirement planning. 

The main issues with the 4% rule are similar to the issues we find with any "rules of thumb." Without understanding the basis, limitations, and core principles underlying a course of action, the user can't really know whether it's right for their situation, why they're doing it at all, or whether there's any reason to believe it's the best available option.  

It's in this context that it's most useful to share some of the less-discussed facets of the 4% rule, to help readers generate a deeper understanding. Even reviewing some of the basics may help someone realize if their situation matches the assumptions of the study in the first place. 


4% Rule: What it is, and what it isn't. 

  • It's not a "rule," it's a research finding. More on this in a bit. 
  • The data studied retirements over 50 years from 1926 – 1976. 
  • It assumed a 50/50 portfolio for all retirees, with the 50% stock component being the S&P 500 representing large cap US stocks, and the 50% in bonds being intermediate term Treasuries. 
  • It did not account for taxes or fees. 
  • It does account for inflation, but the results broadly indicate that high inflation can create serious issues with the success of a plan. 
  • It assumes a 30 year retirement timeline is sufficient. 
  • It does not include legacy planning or spousal longevity in the definition of success. 


So, what's the issue with any of that? 

  • Research vs Prediction: 
    • We strongly support the use of research-backed and evidence-based approaches whenever possible, so to us "research finding" is not a pejorative term. 
    • However, we want any research we apply to have certain characteristicsAmong them: 
      • Pervasive – holding across countries, regions, sectors, and asset classes. 
      • Persistent – holding across long periods of time in different economic regimes 
      • Robust – it holds for a wide variety of definitions. 
      • Intuitive – has a logical or principles-based reasoning for why it should be true, and may not just be an artifact of data that it happened to be true. 
    • As far as I can tell, the research backing the 4% rule doesn't even pretend to be some of these things. Most obviously, the S&P 500 from 1926 – 1976 does not reflect a pervasive representation of equity markets, broadly. 
    • In any case, barring the full list of ideal research characteristics, all we can say of this finding is that it tells us what was true in specific conditions in the past. 
    • This leads closely into the next point... 
  • Market risk:  
    • The rule assumes that investment returns will follow historical averages, which may not always be the case.  
    • Never forget: Past Performance Is Not Indicative Of Future Results.
    • Keep in mind, even the bond component of a 50/50 portfolio is not a lock – in order to do it right, you have to match terms of your assets and liabilities. It's a skilled undertaking, and it can go awry. Bonds do go down, and sometimes at the same time as stocks. Could your plan have tolerated 2022 as its first year (with the S&P 500 down 20% and bond ETF's IEF down 16% / TLT down 32%), or as the last year of pre-retirement? Is your plan to basically hold your breath and hope this isn't you? Hope is not a strategy. 
  • Taxes: 
    • Some people think that taxes are not an issue if most of your investments are in traditional retirement accounts. This is incorrect.  
    • Traditional IRA or 401k funds will be taxed at ordinary income tax rates when withdrawn, and unfortunately none of us can predict what those rates will be 10, 20, or 30 years from now. 
    • If you look ahead to a time when you feel comfortable living on 4% of a nest egg, could you also live on that 4%, minus, for example, 35% (that's 2.6% if you're keeping score at home)? 
  • (True) Liquidity & Shocks: 
    • Liquidity and shocks are two sides of the same coin. 
    • What if something happens and you need to draw above 4% in a given year? What does that do to that 4% you meant to take each year after? There's a clear answer and it's not a happy one. 
    • Often people mistake the existence of a bucket of assets they could theoretically draw from as "liquid" but this is not true liquidity. If you're depending on assets to stay in place to generate future income you will need to live on, then it isn't really liquid. 
  • Longevity (living longer than expected): 
    • The only way to manage longevity risk without risk pooling (a concept too significant to expand upon here) is to reduce your withdrawal rate – in other words, spending less every year of your life, in case you live too long.  
    • This is where the 30-year retirement assumption comes in. It sounds like a reasonable amount of time at first glance, but what if you (or one of you and your spouse) lives 31 years? 35 years? 40 years? Are you comfortable not having money for the last 1-9 years of your life? 
    • To use an analogy: if you had one source of food dropped off today, and couldn't be sure it would ever be replaced, how much would you eat? If you're like many people, you'd ration off just enough to survive, which is how most people approach this retirement problem. Do you think you'd like to do better than this? 
    • To look at it yet a different way: how much money would you need to set aside and not put to work if you couldn't buy home insurance? How inefficient would you be if you knew you might need to have cash on hand to replace your home some day? Of course you might not have to do that, but you wouldn't know, and you wouldn't have a backup plan. At the very least, it wouldn't feel good. 
  • Individual circumstances: 
    • The rule is a general guideline and may not be suitable for all retirees.  
    • Factors such as life expectancy, health, spending habits, shocks, family composition, ages, and expectations can vary widely, and may require a more customized approach to retirement planning. 


Changing conditions: 

So far I've alluded a few times to the fact that things that were true in the past may not always be true. Trying to capture the list of market, economic, and other conditions that have changed or could change since 1976 and 1994 would be (1) unnecessary and (2) outside the scope of this post, but a few quick hits may help draw into relief some of the issues that can arise. 

  • Future tax rates are unknowable and will absolutely affect your lifestyle in retirement. 
  • Interest rates have (pretty famously) changed, both from 1994 when the study was originated, to the past 2 decades, to the past 1 year.  
    • Rates are a major driver of (at least) the bond returns, and they stayed way below the levels of the study period for a very long time.  
    • They are now (in November 2023) higher than they were, but still lower than the study period average.  
    • If someone chooses to take more risk, seeking to offset lower bond returns with a higher allocation to stocks, thus throwing off the 50/50 assumption, then sequence of returns can rear its ugly head and the premise of the 4% guideline is very much in jeopardy. 
  • Market volatility matters to the size of your nest egg before retirement, too.
    • Two otherwise identical (hypothetical) people who retired in February vs March of 2020 could have drastically different entire retirement periods using the 4% rule. 
  • If you aren't quite sure (no one is) how long you'll live or how these factors will play out, maybe you play it conservative and opt for a 3% withdrawal rule – but now you're talking about needing 33% more of an asset-base/nest egg in order to retire and live off of equivalent income. That's not a minor change. 
  • US Stocks are, of course, "International Stocks" to those living outside the US. The historical returns of equities in non-US markets over time paint a different picture of what's safe to assume from equity returns over any given 10, 20, or even 30 year time period. Many people today are diversified at least somewhat into non-US stocks, alternatives, real estate, etc. and it's important to at least understand that none of this fits the profile sketched by the 4% rule and its underlying assumptions. 


I'll leave you with some key quotes from the originator of the 4% rule, Bill Bengen, in a May 2022 interview assessing what has changed: 

  • "Since then, circumstances in the market have become unique." 
  • "My research has been based on studying rates of return and inflation. I couldn’t find anything that matched the situation we had coming into this I’ve suggested that [retirees] may want to be more conservative than my research had indicated was necessary." 
  • "I’ve seen plenty of days in the market now where both stocks and bonds have gone down together. It’s kind of frightening."  
  • "My biggest concern are buy-and-hold advisors who don’t modify their allocation in response to market risk." 


So, what should I do instead? 

Distribution planning is the art & science of assessing where money will come from based on timing, risk, and tax impact. It's a big part of what we do here, and it's the alternative to the above. 

In reality, people's situations vary quite a bit and life is complicated. Some people have significant equity in a few individual stocks due to long-term holds, equity compensation, or other reasons. I've run into zero humans (so far) who actually have a precise 50/50 S&P 500 / Intermediate Treasuries holistic, comprehensive portfolio. Applying the 4% rule blindly when the underlying assumptions and variables don't match up to your reality would strike me as unnecessarily cavalier when your lifetime earnings and multi-decade lifestyle are hanging in the balance. 

Everyone is different and rules of thumb are not appropriate to base major life decisions on. Make sure you understand the full risks and how to mitigate them properly - talk to someone, check your assumptions, and focus your attention in the places that will have the most impact on your life.