Abusing the 4% Rule

The 4% rule says that it’s safe to start retirement drawing 4% of your portfolio in the first year and increasing the withdrawal amount by inflation each year. There are important caveats that come with this rule, but they seem to get lost in the retelling.

The 4% rule originated with an excellent and very accessible 1994 paper by financial planner William Bengen called Determining Withdrawal Rates Using Historical Data. Bengen showed that portfolios with 50% to 75% U.S. stocks and the rest in intermediate-term treasuries would survive well with yearly withdrawals of 4% of the starting portfolio value. The idea is that once the withdrawal amount is set, you only adjust it for inflation; Bengen assumes that you don’t adjust your spending based on your portfolio’s returns.  This inflexible approach is how he calculated his safe initial spending percentage, but he was clear that a real retiree may choose to increase or decrease spending in the face of a portfolio that is declining severely or growing wildly.

Simulating retirements beginning each year from 1926 to 1976, Bengen showed that portfolios of 50% to 75% stocks lasted more than 30 years every time and usually lasted more than 50 years. Of course, he didn’t have 50 years of data for the later retirees, but he could see that these retirees were on a good path.

A detail Bengen never discussed was portfolio fees. I had to look up some of the return numbers he included in the paper to confirm that he was using S&P 500 nominal stock returns with dividends and no portfolio costs.

Let me repeat that last bit: he assumed that the management expense ratio (MER) was zero.

No doubt Bengen is a respectable fellow who had no intention of misleading anyone. Perhaps he invests his clients’ money in a very low-cost manner, and he gets paid out of their yearly withdrawals.

Of course, it isn’t possible to invest without some costs. I pay a rock-bottom 0.12% per year right now. This climbs to around 0.4% or so per year if you use TD’s e-series mutual funds well. The costs get much higher if you pay for financial advice.

The 4% rule works well in its intended habitat. The problem comes when an investor (or his or her advisor) uses Bengen’s research and assumes that it’s safe to apply it to a portfolio filled with a bunch of crappy balanced mutual funds with exorbitant MERs. This is like taking a rule of thumb about how much juice you can get from an orange and applying it to juicing a grape.

Fees matter. Investors and advisors can make fees disappear in a puff of bad logic when misapplying the 4% rule, but reality will strike when your portfolio shrinks faster than you hoped in retirement.