Posted by: drdata921 | May 31, 2013

Does the 4% Savings Withdrawal Rule Really Work

Is the 4% Retirement Savings Withdrawal Rule a Good Guideline or the Path to Poverty?

Successful people ask better questions, and as a result, they get better answers.

Anthony Robbins, Motivational Speaker

When it comes to retirement finances, we all love guidelines. It makes a complex topic much easier to fathom. In retirement planning, one of the most popular guidelines is the 4% rule originally proposed by William Bengen. This rule states that to maintain a positive savings balance over the course of a retirement, you should start by drawing out 4% of the beginning balance. During each subsequent year, you adjust the previous year’s withdrawal upward for inflation. Mr. Bengen found that given historical inflation rates and investment returns, this would extend savings over a normal retirement. Subsequent research has suggested some changes to the guideline to handle volatility in annual investment returns and inflation. However, the rule remains largely intact and a part of retirement planning folklore.

As I have analyzed my own retirement situation, I have become concerned with the 4% rule. The reason for my concern is not how well it addresses the basic question: “How do I extend my retirement savings over the duration.” Rather it is the important question that it doesn’t address: “If I follow the 4% rule, will I have enough money year-to-year to maintain my standard-of-living.” You see, the first question is focused on extending retirement savings while the second is concerned with maintaining a lifestyle. These are two fundamentally different questions. Don’t get me wrong. Maintaining a positive retirement savings balance is important, but this is only one-half of the financial equation.

I decided to do a deeper dive on this issue. To make this assessment, I used the Retirement Funds Longevity Calculator available in the tools tab. It allowed me to evaluate how long my savings balance would last given application of the 4% withdrawal rule and whether I could meet my annual expense needs. For this example, I made the following assumptions based on averages that I found on-line for 2012: My annual retirement income would be $32,000, I could expect a 5% annual return on my savings, and inflation would average 3.4% (the 50 year average after removing some extreme years in the 1970’s and ‘80’s).

Additionally, I assumed that my beginning retirement saving balance would be $500,000. This is greater than the current baby boomer average of $65,000, but this number varies wildly among pre-retirees. Also, $500,000 is close to the guideline around the income multiples you need in retirement. Finally, at the beginning of retirement I assumed that I will need $50,000 per year to maintain my pre-retirement standard-of-living.

What did I find? In this example if I withdrew the funds I would need to maintain my pre-retirement standard-of-living (disregarding the 4% rule), my savings would last for 26 years before they would be exhausted. If, on the other hand, I followed the 4% rule, my savings would last 31 years, five years longer. However, here is the catch: With a 4% + inflation withdrawal rate I would be able to fully cover my expenses for only the first four years of retirement. After that, I would need to lower my standard-of-living. By my tenth year of retirement, I would have 5% less income each year than I would need. By year 20 this would be 13% less. This shortfall would increase to 19% by year 30. In other words, I would need to reduce my standard-of-living beginning in my fifth year of retirement and this would get progressively worse.

So is it thumbs up or thumbs down for the 4% guideline? In this example, the 4% rule worked as advertised? However, would you be able to cover your expenses for the duration of your retirement? The answer to this question is probably not! To provide a perspective, the average person retiring at age 66 could expect to live to age 84 (males) or 86 (females). So expect income to become an issue early into your retirement if you follow the 4% rule. Run your own numbers to get an answer pertinent to your situation. But, use this discussion as a warning against blind application of the 4% rule.

This is an example of how you can get an answer to the question that you ask. However, it may not be the question that you need answered. What you are really asking is whether you will have enough money for retirement. With the 4% rule, things could get dicey during retirement as you struggle to pay your bills. This harkens back to the age-old question: “Do you want to live well in retirement, or do you want to leave your kids a nice inheritance?”

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Responses

  1. Your point in the second paragraph is very correct: The “4% rule”, only gives some visibility into how much a prudent person would plan to initially withdraw from their savings, that amount then being adjusted each year by inflation. I found the various studies, both the empirical (using historical data) ones and analytical (using Monte Carlo techniques) convincing enough. Additionally, it is important to remember that retirees are not programmed machines, we are not ‘committed’ to the 4% for thirty years. If, after several bad years of returns on the savings portfolio, the retiree decides things are not going so well, they can take corrective action, such as tightening the belt a bit, getting a part-time job, or moving in with the kids 😉

    For several years, in order to get comfort that I truly understood what our annual expenses were, I performed a proforma analysis on our income/outgo for the year. Outgo was categorized into major categories such as
    “Savings” (clearly that would go to zero after I retired),
    “Income Taxes” (would be predicated upon my withdrawal rate, not my earnings rate)
    “Medical Insurance” (some of my paycheck went to paying my share of medical, after retirement I would be responsible for the entire share. And this would probably have a higher inflation rate)
    “Large discretionary” (such as vacations or home improvements. These could be deferred if things weren’t going peachy)
    “Everything else” (Food, utilities, day to day entertainment, clothing, auto expense, etc. This number would grow yearly by some inflation rate)

    So the question for me was “Were the numbers predicted by my proforma comfortably within the 4%?” Of course, this approach assumes no major changes to lifestyle.

    Very nice blog!

    • Thanks for the comment. I totally agree. It’s like anything else. Guidelines are nice, but should anyone be on autopilot and can anyone really believe that adjustments won’t be required. Where my post creates somewhat of a conundrum is the reality that it suggests. If you run out of savings, you have a problem. However, if you can’t pay your bills and must significantly downshift your lifestyle each year, you have a problem. So, what to do??? I haven’t quite figured out that one yet, but at least it puts the issue in perspective (versus creating a false sense of security).

      Glad you like the blog!


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