The 4 Percent Rule Overlooks 5 Critical Details

Since William Bengen's original study in the October 1994 Journal of Financial Planning titled "Determining Withdrawal Rates Using Historical Data," the four percent safe withdrawal rate has been a commonly accepted rule of thumb for retirement income planning. Dubbed the "four percent rule," the goal was to provide a steady stream of retirement income while maintaining an account balance that can sustain continued withdrawals for a determined number of years.

Retirement income planners and financial planners alike should exercise caution when it comes to recommending the four percent rule to clients because it overlooks five critical details that can spell the difference between wealth depletion and a happy retirement.

5 Critical Details That Can’t Be Overlooked

1) The context of today’s marketplace

The United States' historical experience is not sufficiently representative to provide a clear idea as to what the safe withdrawal rate should be. Today's new retirees experience a market environment that has very little precedence in the U.S. historical record. The reason for this stark difference in market conditions is that bond yields are low at the same time the stock markets are being overvalued, according to economist Robert Shiller's cyclically adjusted price-earnings ratio (CAPE).

2) Assumed return on investment

The four percent rule assumes investors will earn the underlying indexed market returns with annual rebalancing. Because of this assumption, investors who pay fees, lose money due to an unwise investment, or otherwise underperform the indices should not rely on a safe withdrawal rate of four percent. Retirement income advisors and planners need to have a comprehensive, holistic understanding of their client's' situation to recommend an accurate withdrawal rate in cases where investments underperform.

“What matters for sustainable withdrawal rates is the interaction of portfolio returns and volatility.”

3) Tax burdens

The four percent rule is based on a tax-deferred investment portfolio, traditional IRAs being one example of a tax-deferred account (TDA). While TDAs are commonly used to facilitate financial freedom during retirement, those who choose to withdraw from a taxable portfolio will need to exercise special caution. Taxes play a bigger role than one may expect, often resulting in a much lower safe withdrawal rate than four percent. When dealing with taxable portfolios, taxes must be paid on withdrawals but also on any reinvested dividends, accrued interest and capital gains, even if they aren’t withdrawn. This limits the chance for the portfolio to earn compound growth on the removed tax payments as well as the overall amount from which retirees can draw.

4) The proper margin of safety

One assumption made by the four percent rule is that a retiree will not want to leave a bequest or build in a safety margin. In the worst case scenario, wealth depletion can be expected, leaving the individual faced with unpleasant or even devastating decisions to make. Experts recommend investing with a margin of safety to allow room for error, imprecision, bad luck, and volatility of the economy and stock market. Investing money without a margin of safety today, whether done deliberately or accidentally, is borderline negligent. As your client’s fiduciary, it is your responsibility to calculate and recommend a proper margin of safety.

5) Increased health and longevity

One of the most crucial details the four percent rule overlooks is an increased (or decreased) planning horizon. The four percent rule was based on a planning horizon of 30 years, meaning the individual plans on living off their retirement savings and income for three decades. If 30 years is not the right planning horizon for your clients, the amount they can safely withdraw will change, too. Consider your client’s health, the age of retirement, life expectancy, and other factors to assess an appropriate planning horizon and judge whether or not rules of thumb (like the four percent rule) do in fact apply. Generally speaking, as compared with a 30-year horizon, a 20-year horizon can increase the safe withdrawal rate by 1.3 percent whereas a 40-year horizon should decrease the safe withdrawal rate by about 0.7 percent.

The four percent rule and the probability of running out of wealth are just two pieces of a much larger puzzle that needs solving to help clients enjoy their retirement. However, they illustrate an important distinction between pre-retirement planning and retirement income planning that advisors must address. There are no rules of thumb that can be broadly applied across your entire client base when it comes to retirement income planning and advice — each client is unique, and their situation must be treated as such, for their success and yours.

To gain expert insights and learn how to create comprehensive retirement plans that meet your clients’ unique needs, download “The Guide to Being a Successful Retirement Income Planner.”