The 4% rule can ruin your retirement. Don’t let it do your thinking for you!

Is the 4% withdrawal rate foolproof?

Shortly after I published an analysis of William Bengen’s groundbreaking retirement sustainability work–“Where’d the 4% rule come from, anyway? (Hint: it wasn’t the Trinity Study)”–a reader named Dave offered several excellent insights that unfortunately got buried in the article’s comments. I got in touch with him to see if he minded me splitting his throughts into a new post, and he was fine with that. Thanks, Dave: I’m grateful. I think you’re doing the FI/ER community a solid by sharing your perspective.

Dave’s theme was essentially, “Retirees age 65 (forget 40-year old FI/RE acolytes) are tragically naive if they follow Bengen’s SAFEMAX of 4.15% withdrawal or Trinity’s 4.00% withdrawal and believe them to be sustainable.”

I’d qualify Dave’s statement by saying, “…if they BLINDLY follow Bengen’s SAFEMAX of 4.15% withdrawal…,” because I’ve long thought that many aspirants to FI/ER, especially those new to the concept, use the 4% rule as a surrogate for developing their own model. This is a mistake.

For instance, even Bengen said in his groundbreaking 1994 paper “Determining Withdrawal Rates Using Historical Data” that:

“…the client who retired in 1929 with $500,000 in a retirement fund saw that fund dwindle to less than $200,000 by the end of 1932. Although his withdrawals have also declined from $20,000 in 1929 to $15,300 in 1932, owing to deflation, those withdrawals now equal about 7.6 percent of his portfolio, whereas he began by withdrawing only 4 percent.”

And so while the 4% rule can be a useful benchmark, it’s demonstrably fallible. Again, don’t let it do your thinking for you.


Summary:

In short, retiring at the wrong time can blow up your plan. This is an obvious point in general, but know specifically that any retiree faces two kinds of risk that a time-series metric like the 4% rule can’t protect against:

  • Bull markets in bonds–whether governmental or corporate–can negate the value of a portfolio’s bond component and even render it harmful to total-portfolio returns, and
  • Sequence of returns risk, in which unfortunate timing obliterates one’s savings even at the “safe withdrawal rate.”

It’s necessary for those seeking FI/ER to have a good handle on these two risks

So I now quote from Dave’s commentary. He begins with a few simple principles and then develops his argument.


Dave on bond risk:

With regard to bonds, bond prices/values are inversely related to bond yields. When bond yields decline, bond prices/values increase and vice versa. And the longer the duration of a given bond, the more severe the inverse relationship is.

For a bond mutual fund, the one metric that captures this “interest rate risk” is duration. A bond fund with a duration of 5 years (about right for an intermediate bond fund) generally means that if interest rates go up 1%, the value of the bond fund will decline by about…5%. A bond fund with a duration of 15 (typical of a long term bond fund) would decline by about 15%.

“Bull markets” in bonds are periods of time when bond yields decline. We’ve had a 30 to 35 year bond bull market as yields on bonds have fallen fairly steadily over the past 30 or so years (and they’ve been historically low for several years now). Mortgage rates in the 1980s were 15% or so; today they’re 3-4%. Same is true (trend-wise) with 10-year Treasuries, 30-year Treasuries, and corporate bonds as well.

We can’t possibly be on the edge of a bull market for bonds because there is NO WAY bond yields will drop from plus 3-5% today to minus 10-12% in the future.

No. Way.

Bengen/Trinity bond allocations picked up higher yielding bonds which helped provide a “safe” withdrawal rate (a bond yielding 8% is nice when you want to sustain a 4% withdrawal rate.) And…as the yields dropped, bonds increased in value. That helped Bengen/Trinity too.

What are retirees/FI-RE people using for their bond allocation today? What is the duration of their bond portfolio? What is their bond portfolio yielding? Beats me. I wonder if they know or if they are thinking it’s OK to be 100% in stocks?

Bottom line with bonds is this: going forward they are not going to perform like the intermediate or long bonds Bengen/Trinity models captured.


Dave on stocks and sequence of return risk:

Sequence of return risk is what happens when early in my “retirement” my portfolio suffers a bear market (a drop of 20% or more.) See this for historic returns: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

[Author’s note: bookmark that page. It’s a useful presentation of facts you’ll be referring to a lot, and on it is a link to an Excel spreadsheet of the same data.]

Notice that the S&P 500 did the following:

2000 = -9.03%; 2001 = -11.89%; 2002 =-21.97%

Had enough?

Wait. 2008 = -36.55%.

Retiring with $1,000,000 on January 1, 2000, and taking out $40,000 a year would be pretty tough to do.

So, let’s say I’ve got $1,000,000 and I take out $40,000 on day one of retirement. I’ve got $960,000 invested (75% in stocks = $720k, and 25% in bonds = $240k).

And the stock market, where I have 75% of my assets allocated, drops by the end of the year by 20% I’ll be down to $576,000. We’ll assume bonds yielded 2% for the year so the $240,000 in bonds grew to $244,800 — so there’s bear market in bonds.

Now I’m starting year two with not $1,000,000, but $820,800.

Forget inflation. I want/need $40,000 to cover my expenses. I need to draw down 4.873% ($40,000/$820,800). I take out $40,000 and start year two with $780,800 (with $585,600 in stocks and $195,200 in bonds).

This year stocks drop 25% and bonds drop 3%. At the end of year two, my stock portfolio is worth $439,200 and my bonds are worth $189,344.

I start year three of retirement with $628,544 ($471,408 in stock, $157,136 in bonds).

Forget inflation, I need $40,000 (which is 6.36%) and now my nest egg is $588,544.

So if you have a couple bad years at the beginning of “retirement,” the sequence” of returns can wipe you out. Forget that most humans can’t handle those kinds of losses. What would you or I do if we need $40,000 a year but three years into retirement, our nest egg is less than 60% of where it was when we started? Probably panic.

If we bailed out of stocks then, we’re human but we’re out of the game. The next five years the S&P 500 gains 25%, 18%, 3%, 12% and 10%. The “average annual return” for stocks is pretty decent (I’m not going to do the math here with -20, -25, 25, 18, 3, 12, and 10, but there is a sequence of return that over 10 years is 8%). But if all the good years are late in the sequence and we’ve bailed out of stock, we’re done. And if we withdraw an increasing amount, we’re at best pretty darned panicked.. If the good returns come early, no problem.

Average portfolio returns (stocks average 8% a year for the past 80 years) are of absolutely no value to retirees and FI-RE when you are trying for sustainable withdrawals. It’s the sequence (the order) of returns that make all the difference.

Sequence of return for a 65-year old is one thing. For a 35-year old who is in FI-RE, it’s an entirely different kettle of fish.

This is essentially longevity risk…the risk of living too long.

Bengen/Trinity were assuming a 30-year period for retirement. That’s probably too short for 65-year olds today. Bengen and Trinity didn’t study 40 or 50 years of sustainable withdrawal rates.

As for inflation, if one needs 2, 3, or 4% increase compounded annual in their withdrawal, the $40,000 becomes:

year 2 = $40,800
year 3 = $41,616
year 4 = $42,448
year 5 = $43,297
year 6 = $44,163
year 7 = $45,046
year 8 = $45,947
year 9 = $46,865
year 10 = $47,803.

In 20 years at 2%, the initial $40,000 withdrawal would be $59,437; 30 years it’s $72,454; in 30 years and 40 years on it’s $88,321.

Today’s 40-year old person on FI-RE needs to think about 30 years on at their age 70. Anyone think a million-dollar portfolio will sustain a 2% inflation withdrawal starting with $40,000 (4%) withdrawal?

I do not.

We’ve had 8 years of a bull stock market with very, very little price inflation. These conditions will not last forever. Stocks (and bonds) have bear markets. Inflation will likely return, at some point.


In a second comment, Dave put these insights into an up-to-the-minute context.

The last five years in the 1990s generated historic returns:

1995: 37.20%
1996: 22.60%
1997: 33.10%
1998: 28.34%
1999: 20.89%.

$300,000 on January 1, 1995 invested in the S&P 500 with no additional investments, would end 1999 being worth $1,042,069.

Someone hoping to “retire” on January 1, 2000 with $1,000,000 withdrawing $40,000 on that date and thinking they could increase their withdrawal on subsequent January 1st by 2% was in for a surprise.

The first three years of the ’00s were negative returns of -9.03%, -11.85%, and -21.97%.

By the end of 2002, the million-dollar nest egg (after withdrawals of $40,000; $40,800; and $41,616) stood at $540,157. It would take superhuman efforts to continue taking ever-increasing (by 2%) withdrawals from a nest egg that was just about cut in half in three years.

The next five years were all positive for the S&P 500 and by the end of 2007, even taking 2% inflation-adjusted withdrawals) the nest egg was up to $683,253. Not great but perhaps encouraging.

Then came the Great Recession and the S&P 500 declined by 36.55%, Withdrawing $46,866 at the beginning of that year, the bear market resulted in the nest egg shrinking to $403,788 by the end of the year.

The next year’s withdrawal would have been $47,804 on a nest egg worth a bit more than $400k.

Fast forward to 2016.

The 2% inflation-adjusted withdrawal on January 1, 2016 was $54,911 and by December 2016, the nest egg was $444,457. Eight years of positive returns did wonders.

[Author’s note: a personal anecdote in Dave’s favor is this. My portfolio survived the Great Recession intact, in large part because I’d harvested some tax losses shortly before the crash, luckily raising enough cash to where I didn’t have to sell any of our investments for a couple of years. This kept our losses on paper through the worst of things. Note that I used the word “luckily.” And although I came close, I didn’t panic-sell.]

Two bear markets — the first protracted over three years, the other rather more quickly — coupled with increasing the withdrawal rate by 2% would have been problematic for “retirees”. Withdrawing $55k on a nest egg of $450k is about a 12% withdrawal. Is a 12% withdrawal rate sustainable?

Withdrawing a level $40k (instead of taking a 2% inflation adjusted withdrawal) helps quite a bit even with this extremely adverse stock market environment as the ending balance would be slightly more than $665k at the end of 2016.

Here is another “rear-view mirror” look at sequence of return risk withdrawing a level $40k from a million dollar nest egg starting ten years ago on January 1, 2007.

The second year of this “retirement” has the nest egg getting hit by a bear market (down 36.55%). The eight subsequent years have ALL been positive and the next egg is valued at $1,217,188 at the end of 2016.

Flipping the returns around (so the bear hits in the ninth year of the ten-year period instead of the second)–so this lucky retiree has 8 years of positive stock market gains–ends better with the nest egg valued at $1,442,583. Of course, and the end of the eighth year it had ballooned to $2,258,497.

Bengen and Trinity were important academic works that were insightful GENERALLY, but very, very dangerous for individuals to implement PERSONALLY.

The safe/sustainable withdrawal concept is reasonable in theory but by now, everyone should know that they used historical data that no longer applicable. Said another way, they don’t work today. At all.

A flexible approach in terms of income needed as well as time segmentation and other strategies help. But it is sheer fantasy to believe that a 4% withdrawal rate (forget a 4% withdrawal that increases x% a year) is sustainable.

It is extremely difficult to “keep calm and carry on” when bear markets hit. Which they always have and always will. No one, knows when, why, how big, or how long.


So there you have it.

Again, I’d like to thank Dave for taking the time to share his insights. Any thoughts? Do you agree or disagree? Please  leave a comment below.

Author: ER Dude

Sick of your job? After a thirteen-year career, Early Retirement Dude fled corporate America for good. You can do it too! Visit http://EarlyRetirementDude.com or email EarlyRetirementDude@gmail.com.

17 thoughts

    1. It’s a good reminder that although the long-term trend can be your friend, the short-term trend can wreck you…and I think in the FI/ER community we sometimes focus too much on the long term. As somebody whose early retirement survived the housing bubble, I can tell you that the short-term shouldn’t be ignored. 🙂

  1. i fully aggree. but now who could come up with an up to date SWR ? i am still curious for more details on how you survived the sub-prime crisis; that would make an interesting article.

    1. Go take a look at ERN’s site earlyretirementnow.com. He has a whole series on the new SWR, basically he boils it down to 3%-3.5% tops or the inverse of the 4% rule/25 times expenses to 30-33 times expenses.

  2. The early sequence of returns is often overlooked by people new to FIRE, but if you stick around long enough you’ll stumble on articles like this one that you’ve just written. Hopefully people will learn and then take this into their planning.

    For me, flexibility in retirement is key. Anyone unwilling to reduce their spending or to take on part time work once they’ve retired needs to stay in the game longer to ensure their portfolio is large enough to balance out their rigidity.

  3. All valid points. You have to start somewhere and history is a good guide. Just be flexible. Nobody in their right mind is going to continue spending the same $40k while the economy is collapsing around them. My advise would be this: if there’s NO room for being flexible and cutting back spending when your investments go south, then you need to save more to weather a potentially long storm.

  4. Question (at the bottom).

    If you have $1,000,000 invested in the stock market generating 4% in dividends then you wouldn’t have to withdraw any money the first year unless you lost some of the dividends. Even if you lose 50%, you’d only need to withdraw $20,000. Year two and moving forward, you’d need to continue to withdraw the difference and include an amount for inflation as well. I don’t see the amount ever being equal to your required expenses (assuming $40,000) unless you’re not in dividend stocks. This also assumes that you have no other income such as social security or passive income. In addition, I’m in Canada so dividend income (under $50,000) is favoured very well with respect to taxes so I’m assuming that my gross is also my net.

    Approximately 75% of my retirement income comes from dividends (less if you include Child Benefits and Random Passive income) . I’ve never really looked much at how long my money would last without the dividends, good or bad years.

    Am I not preparing myself for all the potential outcomes? What is the rule of thumb for relying on dividends in retirement, especially during tough times?

    1. Given the numbers you cite I personally wouldn’t take an approach like that.

      If you look at FTSE Canada, for instance, you’d currently only be collecting a 2.67% yield, meaning that to get a 4% yield you’re doing your own stockpicking (which further means you won’t have a bond component at all given the current bull bond market, which would require you to pick stocks yielding enough to average out our current near-zero interest rate environment. Lacking a bond component isn’t in my opinion a big deal just now, but the time may cycle back around when you’ll want one.)

      Anyway, since we’re in an eight-year bull market for stocks, picking high-yielding ones that also have the potential for appreciation might not seem so difficult to some, but during a 40%-ish downturn like some of us had in 2008…well, you get the picture. And you have to remember that high-yielding stocks tend to have slower price appreciation.

      A method like you describe assumes an unchanging personal income tax code.

      IMO measuring broad market return across time is best done using dividend reinvestment. Beware apples-to-oranges.

      As far as a rule-of-thumb for relying on dividends: the 4% rule is itself a rule of thumb. Dividends or capital gains; it’s all-in when you’re talking about dollar value of withdrawal. But that gets us back into the tax code too.

      1. I have been doing some research on allocating the stock portion to dividends and then the bond portion on ….. the evil A word Annuity. If I divided 2/3 to dividend stocks that have paid and increased their dividend for a minimum of 30 years spread evenly across 40 companies the yield was 3.58%. The other 1/3 was in an annuity paying around 4.8% (never increasing). The combination make a 4% starting payout rate.
        Yes there is risk that the companies stop or decrease dividends but these have been paying and increasing for 30 years and there is always risk.
        The yearly “salary” increase due to inflation is taken care of by the increase in dividend payout. The average yearly increase of these 40 companies was approximately 4%. That gets an increase of 2.5% on the total. All of this without touching the 2/3 principle invested in stocks and the “guarantee” of minimum income from the annuity.
        What are the flaws in this sort of thinking?

        1. Well…bond yields are obviously in the toilet, true. But as you know:

          -The dividends of your 40 stocks will vary, which I see as the biggest flaw.

          -Your annuity doesn’t adjust for inflation, when it may very well have to carry a market downturn for a number of years.

          -You don’t include any other potential sources of income, like Social Security or a side gig. (A definite flaw in this kind of thinking is failing to consider upsides. Yes, I get that in a decision like this it’s wisest to be conservative.)

          I’ll come back and edit with any further thoughts I might have, and I’m sure the readers of this thread will have their own. But off the top of my head those are three I see.

          1. “The dividends of your 40 stocks will vary, which I see as the biggest flaw.”
            That is why I chose 40 that have paid and increased their dividends for a minimum of 30 years.
            The annuity does not adjust for inflation but that “salary” increase for inflation comes from the increase in the dividend payout of the stocks. Those stocks averaged a 4% increase yearly in dividend.
            Yeah I don’t include other sources of income because that is just extra. My theory gets you to 4% starting with increases for inflation and not touching 2/3 of principle ever.

        2. Mike, is that an immediate annuity in that you’re paying a lump sum and never getting the principle back? Or is it a fixed annuity for, say, 10 years with a return of principle? And if it’s an immediate, how old are you? (the older you are the higher the rate)

          Generally I think the only time an annuity makes sense is when you’re filling an emotional need at a financial cost. The above math isn’t necessarily wrong, but if you put that same 1/3 into a bond fund or a strong income mutual fund you’d likely get similar returns (but no emotional guarantee). Also, if really strong inflation returns (like it did 40 years ago) that fixed annuity (without an inflation rider) will really suffer. Of course, your dividend paying stocks will likely increase their dividends to help offset it.

          I hit FI recently and generally prefer the “take the rising dividends” strategy over a flat 4%. I’m pretty sure this will be my personal strategy.

          1. The Annuity in the calculation is fixed. I was figuring an age of 51 which is my target. I got the number from immediateannuities.com/
            Most of the time when I have looked at bond funds to get the over 4% you have to take out principle so after a number of years that part of the income stream is exhausted. With the Annuity (I know that is an evil word) you get no increase but I have it for the rest of mine and my spouses life. No draw down. Also if you are older that payout goes up of course so to get the 4% total payout starting it is easier to find the stocks. The main thing that I was looking at with this research was to see if 4% was still realistic. With this approach it seems as though it is even at age 51 because you have not touched the principle that is in stocks paying dividends. They can go up or down in price but that doesn’t effect your check. I actually think that probably 20 years of this consistency is fine because that covers the Great Recession.

  5. Sarah: I’m not sure I fully understand your question but I can tell you relying on only dividends during retirement could be a GREAT plan, IF: You are ok with fluctuating but growing income (that will likely start at less than 4%), and your investments are diversified and solid enough that they generally continue to pay rising dividends. And while much of my family lives in Canada, I do not so my knowledge there is zip. Keep in my (at least here in the states) dividend income normally -is- treated at a lower rate, but only if it’s in a non-retirement account.
    Dave: Yes! Thanks for taking something simple (a little too simple) and making it realistic. (In the FI community we tend to oversimplify a bit). All excellent points. The 4% rule doesn’t take into consideration human behavior aka FREAKING OUT. And historically us humans very reliably freak out when the crap hits the fan, despite any well-laid plans.
    ERDude: “Reasonable in theory”. Well summed up!

  6. Hmmm … interesting read indeed! What would you recommend someone with “only” a million dollar 401K do when he/she is 60? For the time being, I like dividend paying stocks, but I think people need to seriously work on creating multiple streams of income. I know so many ordinary folks with extraordinary talents that they just don’t capitalize on.

Leave a Reply

Your email address will not be published. Required fields are marked *

Rockstar Finance

Important Disclaimers