Revisiting the 4 Percent Rule

Many people have opinions about William Bengen’s 4% rule for annual retirement spending. William Bernstein said that 2% is “secure as possible,” 3% is “probably safe,” 4% is “taking real risks,” and at 5% “you had better like cat food.” However, Frederick Vettese says 5% is “relatively safe” and that 6% or 7% “might not be outlandish.” Here I examine Vettese’s reasoning for these conclusions in the chapter “Revisiting the 4 Percent Rule” of his book The Essential Retirement Guide.

Bengen’s original 4% rule is based on a fictitious retiree with no spending flexibility at all. Upon retiring, the retiree chooses a yearly spending dollar amount and increases it by the cost of living each year without regard to how his or her portfolio performs. Bengen tried to figure out what percentage of your starting nest egg would give a safe spending level. Using historical U.S. stock and bond returns, he came up with 4%.  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.

So, if you start with a million dollars when you retire, spending $40,000 per year rising with inflation is probably safe for about 30 years. Keep in mind that in the second and all subsequent years, you aren’t necessarily spending 4% of your portfolio each year. If your portfolio performs well, you may be spending less than 4% of what you have left, but more likely you will be spending more than 4%.

Vettese chose to interpret “4% rule” differently. He assumes that you would spend 4% of whatever is left of your portfolio each year. This implies that you are quite flexible in how much you spend. It also implies that you could never run out of money because you never spend all of it. I’ll distinguish these two approaches calling Bengen’s the “initial 4% rule” and Vettese’s the “4% each year rule.”

A major problem with the 4% each year rule is that it takes no account of your age. As your remaining life expectancy diminishes, it makes sense to be able to spend increasing percentages of your savings. With one retirement spending strategy I worked out, the percentage of your portfolio you spend is 4.17% at age 60, 4.43% at age 65, 6.17% at age 80, and continues to rise. The actual dollar amounts don’t necessarily rise, though. Your portfolio is unlikely to keep up with these ever-rising percentages, so each year you’ve spending a higher percentage of a shrinking inflation-adjusted portfolio balance. The percentages are chosen so that if your portfolio performs as expected, the yearly inflation-adjusted spending amounts remain constant.

Vettese goes on to run Monte Carlo simulations of a 5% each year rule from age 65 to 80. He assumes you’d buy an annuity at age 80. Based on these simulations he concludes that this approach is “on the right track.” The implication is that we can compare this 5% each year rule to Bengen’s initial 4% rule. But this is an apples to oranges comparison. With Bengen’s rule, unless your portfolio outperforms, you’re withdrawing more than 4% each year because his 4% refers to the starting portfolio size. In fact, Vettese may have you spending less than Bengen after the first few years.

Comparing Vettese’s 5% each year rule to my retirement strategy discussed above, I actually have you spending an average of 5.07% during the years from age 65 to 80. So, Vettese hasn’t given you an extra 1% to spend. What he’s done is boost the amount you spend in your 60s at the expense of what you can spend thereafter.

An unfortunate artifact of the 5% each year rule to age 80 is what happens after buying the annuity. An 80-year old male can buy an annuity that pays out over 9% per year. Even if the payments are indexed by 2% each year to partially offset inflation, the starting payout is still over 7%. But with Vettese’s plan, you only get to spend 5% at age 79. His simulations have you scrimping in your late 70s so you can live larger after turning 80.

Overall, just comparing the percentages (4% and 5%) in the two rules is highly misleading. The only time it makes sense is in the first year of retirement when Vettese has you spending more than Bengen does. After that, the comparison is more complex.