“On Retirement Income” series:
- A 4% Rule Fable
- The 4% Rule Launches a Bigger Discussion
- From Mindless Inconsistency to Mindless Consistency
- Stock/Bond Portfolios and Sequence-of-Returns Risk
- Goals-Based Investing Starts with Goals
- Guaranteed Income Sources (Social Security, Etc.)
- How Guaranteed is Guaranteed Income?
- Get Real Income by Getting TIPSy
- TIPS Q&A
- More to come…
4% Rule Q&A
The famous “4% Rule” was originally devised by financial advisor Bill Bengen back in 1994. Bengen looked at historical returns to stocks and bonds and discovered that an investor starting in any previous year could have:
- Withdrawn 4% from a “normal” investment portfolio (anywhere from 40% to 75% stocks) in the first year.
- Increased the withdrawal amount each year to match the inflation rate in the interim.
- Continued this withdrawal process for 30 years without ever running out of money.
In our prior narrative, we illustrated how autopilot application of the 4% Rule could lead to seemingly wildly inconsistent financial advice. Yet it is still a popular rule of thumb, at least as a springboard for more in-depth analysis.[1] Consequently, before moving on to other strategies, we should answer some questions about the 4% Rule. (Thank “you” in advance for “asking” exactly the questions we wished to answer, by the way. How do “you” do it?[2])
Hasn’t the 4% Rule held up remarkably well over time?
It’s important to recognize that the 4% Rule’s historical success was true by construction. Before beginning his research, Bengen obviously knew that the entire stock/bond market had never gone to zero over the available history. That fact alone was sufficient to guarantee that some number would work as a “safe withdrawal rate” over the entirety of that history. That number turned out to be 4%ish. Had it been any other number (“X%”), we wouldn’t be saying the 4% Rule hasn’t worked, we’d just be talking about the historical success of an “X% Rule” instead.
Why does that matter?
The 4% Rule can feel like a conservative approach, because it was the procedure that withstood the worst observed historical backdrop. Indeed, for most historical observations, a retiree could have pulled a higher initial percentage, sometimes a lot higher, and still not run out of money.
But from the perspective of a so-called “safe withdrawal rate” (i.e., an income rate that never runs out of money even with inflation adjustments), 4% can also be viewed as aggressive, because it is the highest percentage that might possibly always be safe, based solely on historical data.
I.e., for anything higher than 4%, we (or Bengen) could point to actual historical observations that would prove the possibility of failure. But do we know that no future market conditions are feasible that would make even a 4% initial draw fail as well? Of course not! And if we got a future set of market returns that would have required, say, a 3% initial draw, would we know that an even worse sequence of returns was impossible? Also of course not!
But hasn’t the 4% Rule still held up well since it was first proposed?
Smart question! (Glad you thought of it.) The years since 1994 are what statisticians call “out-of-sample” data, and they are indeed an important test that the 4% Rule has thus far passed. But the rule was designed for a 30-year retirement. And despite the rule’s attainment of venerable, folkloric status in the (newish) industry of financial advice, even a single 30-year period has yet to elapse since it was introduced in 1994. In fact, the entire available history—in the original research and subsequently—includes only 3 or 4 independent (i.e., non-overlapping) 30-year periods.[3]
One more point before we move on: “Safe withdrawal rate” aside, the 4% Rule itself is odd in principle, because it completely ignores the vagaries of what happens with your investments once you start taking income. It applies a nonvolatile income overlay to a volatile investment portfolio. Hence the oddities uncovered in the last article. In the next article, we’ll consider what might happen if you swung all the way in the opposite direction.
Hey, I just thought of this: What if I live more than 30 years?
Really good point! We’ll get to that. Just not in this article. Or the next couple.
And what if I live less than 30 years?
Then you’ll probably die with extra unspent money. Being dead, though, we strongly suspect you won’t let that bother you. (More seriously, there’s a valid point in here somewhere. We’ll get to that later too.)
Okay, so how do I actually achieve safe income in retirement?
Also, how do I avoid unnecessarily dying with a ton of money (or alternatively, accomplish leaving a large legacy) if the markets do well?
Naturally, those questions each have different answers. You may be surprised by just how different we think the answers are, though, not just in terms of technique, but in terms of the investments or other products required to best achieve each goal.
Future articles in this series will deliver our solutions to these inquiries, as we clamber up the layers of Round Table’s Layer Cake retirement income and investment methodology toward a fully-formed, truly goals-based investing solution.
Is there anything else you’d like to add?
Anyone who has read—or glanced at—my prior articles will likely sympathize with certain unnamed individuals who have challenged me to adjust my didactic dial back towards the brevity end of the detail spectrum.
Ahem, trying again: Some folks have asked me to write shorter articles.
One way to do that is to split a gigantic topic like retirement income into many smaller articles. (Ta-da!) Yet somehow in this article, I both failed to fully achieve my terseness target and I’m cringing at the omissions and lack of supporting detail above. I’ll have to work on that. But if you braved the former failing and made it this far, please accept my invitation to reach out to us if you’d like to learn more…or if you’d like to skip straight to the part where you and Round Table have a personalized discussion about your own retirement investment plan!
[1] Case in point: That’s exactly how we’re using it in this article series!
[2] If I’m going to engage in the popular conceit of a “Frequently Asked Questions”-style article, I can at least make fun of myself for it.
[3] Granted, since the sequence of returns (and not just the end-to-end total return) plays a significant role in the outcome of this study, investigations of overlapping timeframes may be more valuable than they would be in sequence-agnostic contexts. Nonetheless, while 90-120 years feels like a long time to an investor, it is represents a comically small sample of 30-year periods, and statisticians would rightly scoff at any firm conclusions drawn thereby.
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