Why the 4% Rule Fails

Sep 15, 2016 by

Feels like a good day to debunk another verse from standard personal finance “expert” bible: the 4% rule.

What’s the 4% Rule?

Stated simply, the so-called 4% rule is this: withdraw for living expenses 4% of your retirement nest egg annually, and you’ll never run out of money (or, to be fair, you’re very unlikely to run out of money).

So the 4% rule is one of those rules of thumb on which lazy financial advisors rely instead of actually doing the case-by-case work necessary to help assure clients that they can depend on a secure retirement. It’s a way to grow an advisor’s hourly pay, in other words.

Why the 4% Rule Fails

In a world in which the future unfailingly follows historical averages, the 4% rule would work beautifully.

But none of us can forecast reliably the future, and the world—especially the financial world—is a volatile place.

And here’s where the 4% rule falls apart. Virtually every personal finance expert recommends investing a large portion—up to 100%–of a retirement nest egg in stocks. “You could live another 30 years!” is the rationale. “And stocks historically have gained [the inescapable implication being, ‘will gain’] 6% annually. You have to be invested in stocks or you risk running out of money before you die.” That last bit usually clinches the sale—no one likes to envision life in one’s 80s or 90s in a low rent nursing home supported by dependents.

Left unsaid is that just in the past 15 years stock values have twice crashed by 50%. Stock investing is risky, my friends, especially after you’ve retired.

To illustrate my point I’ve constructed a few simple scenarios. Imagine this:

  1. You retire with a $500,000 nest egg.
  2. Dutifully following standard financial advice, you resolve to withdraw $20,000 (4%) annually from your nest egg to supplement your Social Security income. Let’s assume your withdrawal increases 1.5% annually to keep pace with inflation in your cost of living.
  3. Again because you’re dutiful, your nest egg is invested in stocks. Let’s assume your nest egg earns, on average, a 6% annual return.

Okay, you’re set, or so you’re encouraged to think.

But who thinks that over a 30-year retirement horizon stock values will never crash? Right—nobody, not even your financial advisor. Ask her.

So let’s build into your 30 years of retirement a conservative assumption of just one stock market crash. (Remember: two 50% crashes have occurred in just the past 15 years.) For this illustration, here’s how I’m defining a crash:

  • Overall stock values decline by 20% a year for two years in a row.
  • In year 3 (the year following the two years of steep declines), stocks return zero.
  • In each of the other 27 years in the 30 years of retirement I’ve modelled stocks return 6%.

Have a look at this not-so-pretty picture then, which tracks your nest egg balance over 30 years:

why the 4% rule fails

 

In addition to a dreamy “no crash” scenario, I’ve incorporated three stock value crash scenarios. The three crash scenarios differ only in the timing of the crash:

  • Early Retirement Crash means in years 1-3
  • Mid Retirement Crash means in years 14-16
  • Late Retirement Crash means in years 28-30

The lines depict your nest egg balance.

No Crash

Of course with the it-ain’t-ever-gonna-happen no crash scenario (purple line), the 4% rule works as advertised: not only do you not run out of money, your nest egg actually grows, reaching nearly $1 million.

Late Retirement Crash

The late crash scenario mirrors the no-crash, until the crash happens in year 28. By that time your nest egg is so big and you’re so near death (sorry about that), your retirement is not trashed.

Mid-Retirement Crash

But with a Mid-Retirement crash (red line), things start getting a little scary. Less than $200k of your nest egg remains after 30 years, and I bet you’d be feeling a bit stressed watching the balance after about year 15.

Early Retirement Crash

Now check out the Early Crash scenario (blue line). Disaster. Your nest egg is gone soon after just 20 years of retirement. If you retired at age 60, you’re broke at age 80. You’d have to figure out how to live on Social Security alone for the remainder of your life.

Impact of Multiple Crashes

Since Wall Street types are big on citing the past when selling stocks, we should imagine the impact on a nest egg if two crashes happen during a 30-year retirement (this is just half the rate of crashes we’ve experienced so far in the 2000s).

I didn’t model a two-crash scenario, but as I’m sure is clear to you from the picture above, the impact of two crashes would surely mean running out of money except in the unlikely scenario of two nearly back-to-back crashes very late in the 30-year retirement time horizon.

If Not the 4% Rule, Then What?

The 4% rule is prone to failure not because 4% is too much to withdraw but because the rule is always coupled with advice to invest heavily in inherently risky stocks, even in retirement.

No nest egg will dependably last 30 years, pretty much regardless of the withdrawal rate, if it’s invested in assets with values that tend regularly to “go poof.”

I cannot give you suggestions on how to invest your nest egg because I know nothing about your situation. I will tell you that, with Ms. Money Counselor and I retired at least from “careers” and steady paychecks, only about 15% of our total financial assets are invested in equities.

Why do we have so little invested in stocks, contrary to virtually all “expert” and personal finance blogger advice?

Easy.

First, we earn plenty on our nest egg, without being heavily invested in stocks. (You can too. Read my Simple Guide “Build Wealth WITHOUT Stocks” to learn more.)

Second, I’ll be damned if I’m going to be forced back to full-time employment doing something I’d prefer not to be doing because of rigged financial markets and all the other Wall Street and central bank shenanigans. In short, I will not trust my retirement security to forces I don’t at least partly control nor fully understand (nobody does).

When the 4% Rule Can Work

If you don’t mind (and think it will be feasible) going back to work in your 70s or 80s and/or you’re willing to put your retirement lifestyle at risk, then heavily investing in stocks while retired is a fine idea.

But the sad and reprehensible part is that many retirees blindly accept standard financial advice about the 4% rule and investing heavily in equities without understanding—because no one explains it—the risks they’re running.

Don’t fall into this category. Get independently educated, and don’t rely for financial advice on anyone whose compensation depends on the investing decisions you make.

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  • Interesting analysis. I just did a ton of research on the 4 Percent Rule reading Bengen’s paper, the Trinity Study, their updates, and a bunch of articles from other researchers. In general, all of them agree that too many stocks or too many bonds will not be optimal. The major conclusions from Bengen and The Trinity Study suggest portfolios made up of somewhere between 50-75 stocks. Bonds, of course, help to keep you grounded. Kitces usually uses 60/40 stocks to bonds for his examples.

    I was surprised to learn that Bengen’s paper actually showed that 4 percent was safe for a minimum of 33 years. Most of the other rolling periods actually worked for longer than 50 years! In his update, he actually increased his SAFEMAX rate to 4.5%.

    • Everyone needs to assess their own situation based on a host of factors, in my view. For my situation, there’s no way I’d be 60% in stocks at my age (59). About 15% of our financial assets are in stocks, and they’re all high dividend payers. I’m more than happy to sacrifice potential (and highly speculative) return in exchange for the peace of mind that I’m not going to have to resume a full-time job at age 60+ or slash my spending because of yet another Wall Street calamity.

  • Ian Bond

    This “rule” came about in the 90’s and isn’t relevant any longer. Rates were high and you could finance retirement with CDs. It’s folly in today’s environment. Great analysis!

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