A Quiz on the 4% Rule

Reporters and bloggers write endlessly about William Bengen’s 4% rule for retirement spending, but its details are widely misunderstood.  So, I’ve created a short quiz to test your knowledge of this rule.  I give answers below, but this isn’t multiple choice, so you’ll have to decide for yourself how closely your answers match reality.

1. Jane retired a year ago with $500,000 saved.  She is using the 4% rule, so she initially withdrew $20,000 to spend during her first year of retirement.  Today it’s time for her next withdrawal, and her portfolio has grown from $480,000 to $505,000.  Inflation was 2%, and she’s now 66 years old.  To follow the 4% rule, how much should she withdraw today?
   
   
2. Jane pays a hefty 2.5% MER on her mutual funds.  If she reduces her costs to only 0.5% per year, how does that change her withdrawals under the 4% rule?
   
   
3. Tom saved aggressively during his working years and retired at 45.  How does the 4% rule apply in his case?
   
   
4. Jim is a very conservative investor.  He invests only in GICs and bonds.  Does the 4% rule apply in his case?
   
   
5. We can’t count on getting the same returns that U.S. investors got during the period of Bengen’s study.  How does this affect the 4% rule?
   
   
6. Is there anything we can do to increase our safe portfolio spending level, other than shortening our retirements?

Answers below:

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1. To follow the 4% rule, Jane should withdraw $20,400, which is her original $20,000 increased by 2% inflation; the rest of the figures in the question are irrelevant.  If you answered $20,200 (4% of the new portfolio value), you’re not alone; this is a common misconception.  The 4% rule ignores portfolio performance after retiring.  The percentage of your portfolio you spend each year after the first year will depend on how much it has grown or shrunk.  You just keep spending the same inflation-adjusted amount each year and hope your money doesn’t run out.  If instead you spend 4% of your updated portfolio value each year, you’re guaranteed to leave a sizable inheritance, and your odds of having your inflation-adjusted spending decline alarmingly over the years is quite high.  If you answered $20,000 because you thought spending stayed constant over the years, you’re close.  The idea is that spending after adjusting for inflation stays constant.  This inflexible approach is how then originator of the 4% rule, William Bengen, 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.
   
   
2. William Bengen’s original study took no account of portfolio costs.  He used historical U.S. stock market returns to establish his 4% rule.  So, to follow the 4% rule strictly, Jane’s withdrawals wouldn’t change.  It’s tempting to say that because Jane is saving 2% each year, she can bump up her withdrawals to 6% of her original portfolio size (rising with inflation).  However, there are two problems with this.  The first problem is that as Jane’s portfolio shrinks (in a scenario where returns are weak), the 2% MER savings on a smaller portfolio don’t fully offset 2% higher withdrawals calculated on the starting portfolio value.  On average, saving 2% on costs makes safe withdrawals only about 1% higher.  The second problem is that Jane’s high-cost portfolio couldn’t really handle spending at 4% of the starting portfolio size.  In reality, repeating Bengen’s study to account for costs would have Jane using a little less than a 3% rule.  So, by reducing her costs, she is improving the chances that she won’t run out of money with the 4% rule, but she probably shouldn’t increase her planned withdrawals.
   
   
3. The part of Bengen’s study that produced the 4% rule assumed 30-year retirements.  This would take Tom only to age 75.  So, the original 4% rule doesn’t apply well in his case.  He expects to have a long retirement, and has to reduce the spending amount from his portfolio somewhat to compensate.  Bengen was clear that the expected duration of retirement needs to be taken into account when choosing a starting withdrawal percentage.
   
   
4. Bengen’s 4% rule came from portfolios 50-75% in U.S. stocks, and the rest in bonds.  This doesn’t apply to Jim’s case.  Suppose Jim expects the returns on his GICs and bonds to match inflation.  Then he can just divide the length of his retirement into 100%.  For example, to cover 40 years of retirement, Jim can spend 2.5% per year rising with inflation.
   
   
5. The 4% rule is based on the worst-case starting year of retirement.  In U.S. data, the worst periods include the aftermath of the 1929 stock market crash and the poor inflation-adjusted stock returns from the late 1960s to the early 1980s.  So, the important question is how likely your returns are to be worse than these periods.  The eye-popping U.S. returns in other time periods isn’t relevant.  So, the fact that experts believe future returns won’t match historical U.S. returns isn’t a positive thing for your retirement, but it’s not as bad as it seems for the 4% rule.  Adjusting down to a 3.5% rule may be sufficiently safe.  Having to reduce the withdrawal percentage further by about half of portfolio costs is a bigger concern for many Canadians.
   
   
6. Yes.  We can be more flexible with changes to the amount we spend each year.  This means being prepared to spend less if returns disappoint.  Bengen’s study assumed no flexibility at all.  At the other extreme of very high spending flexibility, we could use something like the table of RRIF withdrawal percentages that tell you how much of your current portfolio to withdraw each year.  These percentages are probably about right for someone paying about 1% each year in portfolio fees.  However, this plan could have your inflation-adjusted spending level change drastically over the course of a few years.  Not all of us can be this flexible.  There are intermediate levels of flexibility with plans that set spending floors and ceilings.  However, the less flexible your spending plan, the lower your starting spending level needs to be.