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.
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.
love the analogy: "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."
ReplyDeleteyour perspectives on retirement income are very helpful. thanks!
@Unknown: Thanks. I figured I needed an analogy to make my point more memorable. It took me a while to come up with that one.
DeleteMichael, while there is debate on how many active managers beat the market, is it not incumbent upon each individual investor to ensure their manager at least hangs around market returns after fees and if not, move on to another advisor or low cost index funds? The rule has flaws, like fees and ignoring taxes, but why pay fees if you are not getting the return? To me the flaw is more attributable to the investor than the rule itself.
Delete@Blunt Bean Counter: It's not possible for all individual investors who pay active managers to make market returns. Active managers dominate the market and so must receive the market average returns before fees. We can decide that individual investors have the responsibility to see to it that they at least meet the market return, but the reality is that most will not and it's not possible for all of them to do so.
DeleteI agree that the problem is with the misapplication of the rule rather than the rule itself. But those who discuss the rule have a responsibility to explain properly how to apply it. A simple way to explain it is that you have to pay any fees out of the 4% withdrawal.
Sigh. I was going to take the kids out for supper. After reading this, I'm going to be cooking again--I may want that extra money more in the future than today....
ReplyDelete@BetCrooks: What's for supper? I'm getting hungry :-)
DeleteNow you're sounding like my eldest: first question every afternoon!
DeleteAlternate title: "4% Rule or 7% Solution?" Sad state of affairs when closet indexer-huggers can take 1/2 of someone's investment returns.
ReplyDelete@Gene: Definitely sad. I had to look up the 7% solution. Apparently, Sherlock Holmes describes cocaine as a 7% solution. I guess cocaine is expensive too :-)
Delete