The fundamental purpose of the 4% rule is to determine an appropriate spending floor for older investors that is low enough to survive the worst return sequences that can be found in the historical data. If market returns going forward turn out to be as bad as the Great Depression or the stagflation of the 1970s, the portfolio is still expected to sustain inflation-adjusted spending to the end of a 30-year time horizon. If returns are better, there will simply be extra money left over.
Yet the reality is that in most historical scenarios, returns are not so bad as to necessitate an initial withdrawal rate of only 4%.
In fact, by adhering to a 4% withdrawal rate, more than two-thirds of the time the retiree finishes with more than double his or her wealth at the beginning of retirement, and one out of two retirees nearly triples the original wealth.
Accordingly, a better approach is to resolve in advance that if the portfolio gets far enough ahead, spending can be increased above the initial floor amount but not so much that the retiree might have to reverse direction thereafter.
A relatively simple ratchet-style approach, where spending is increased by 10% any time the portfolio rises more than 50% above its starting value, works in all scenarios, and yet is conservative enough to not require a spending cut in the event of a market pullback.
The origin of the safe withdrawal rate was straightforward. It was simply designed to sustain inflation-adjusted spending over a 30-year period given the worst-case investment scenario in U.S. history.
Overall, the initial withdrawal rate that would work for a 60/40 portfolio over any particular 30-year time horizon has varied between 4% and 10%, with the median close to 6.5%. But since we dont know whether the next 30 years will be a period of high, low or average returns, the idea is simply to treat every time period as though it might turn out to be the worst.
Accordingly, if the next 30 years turn out to be another stretch of horrible market returns like the other time periods that necessitated a 4% initial withdrawal rate, the 4% rule will work, and the portfolio will make it to the end (albeit just barely). If the results are better e.g., a 5%, 6%, or even 10% withdrawal rate would have worked, but the retiree only followed the 4% rule there will simply be excess money left over.
Yet, in reality, an overwhelming majority of historical scenarios do not necessitate a 4% rule, and adhering to this approach usually results in an excess of unspent wealth.
In fact, in only 12 of the 115 rolling 30-year periods from the early 1870s to the present did a retiree who started with $100,000 in an annually rebalanced 60/40 portfolio finish with less than the original principal, even after a lifetime of inflation-adjusted spending starting at a 4% withdrawal rate.
Those who did finish with less were all retirees who had the misfortune of retiring just before a calamitous event, such as the start of World War I. Since 1920, such an outcome has occurred only four times: for those who began their retirements in 1929, 1937, 1965 and 1966.
Thus, by following the 4% rule, more than 90% of retirees finish with more than their starting principal after 30 years, and the typical retiree actually finishes with many multiples of his or her starting wealth. The median wealth after 30 years is almost 2.8 times initial principal. One in six finishes with more than quintuple his or her initial wealth.
Since the 1920s, the odds of doubling starting wealth is 80% and more than a third of retirees finished with over five times the starting retirement portfolio.
Yet some have raised the question of whether the 4% rule is too high given todays low return environment.
RATCHETING UP SPENDING
While the 4% rule was created to set a minimum income floor, that doesnt mean spending can never be raised.
After all, no planner is going to sit down with an 86-year-old client who retired with $1 million and now has $5 million and say, No, you shouldnt spend a single dime more than $75,000 a year, because thats what the 4% initial withdrawal rate dictates.
Obviously, at some point, when returns have been good, its safe to spend more, and in the real world people do make such adjustments.
So we know that there will be situations where the results are ahead of the worst-case scenario and its safe to spend more. But what we dont know based on the research to date is how far ahead the account needs to be to safely increase spending and raise the income floor.
As it turns out, it doesnt take all that much. A notable consistency among all the scenarios where the retiree fully or nearly depletes wealth within the 4% rule is that because of early adverse market returns, the balance never gets much higher than its starting point.
But it also turns out that any time the account balance grows 50% above of its starting value (after withdrawals), the portfolio is already far enough ahead that it wont be depleted over a 30-year time horizon and there will be extra money left over.
Thus, a straightforward way to establish a new, higher, income floor is simply to commit that spending will be increased (beyond annual inflation adjustments) once the account balance grows 50% above its initial amount.
The caveat is not to ratchet it up too much or too quickly.
For instance, the rule might be that any time the account balance is up 50% over the original value, spending is increased by 10% (over and above any ongoing inflation adjustments), but such spending bumps can occur only once every three years at most.
As an example of how this might work, the chart below shows inflation-adjusted (real) spending by applying this rule in three different scenarios a retiree starting in 1966, 1973 or 1982.
With the 1966 retiree, the spending kicker never happens. Because of years of poor market returns and high inflation, the account balance never even gets 20% above its initial starting value.
As a result, a 4% initial withdrawal rate (or $4,000 on the $100,000 portfolio in the chart), adjusted each year for inflation, simply results in $4,000 a year of lifetime inflation-adjusted spending with no positive adjustments.
For the 1973 retiree, the account balance falls behind initially because of the market crash of 1973-1974, but eventually recovers, breaking the 50%-of-starting-balance threshold. This results in a series of income jumps during the last decade of retirement.
In the case of the 1982 retiree, however, a bull market benefits the retiree from the start, leading to an income boost every three years throughout retirement.
In fact, the ratchet approach increases spending at least once in almost all historical scenarios; the only times a ratchet does not occur are scenarios where a highly adverse sequence-of-returns occurred early on, and the portfolio barely had enough money to last for 30 years in the first place.
Just as the purpose of the 4% rule is to set spending low enough so that even if an adverse event occurs, spending can be maintained, the point of these ratcheting rules is, like a ratchet itself, to ensure that spending adjustments only move ones retirement spending up and never down.
In fact, these targets for the size of spending increase and the target threshold to apply them are probably still too conservative.
Of course, these ratcheted spending increases along the way do have a cost the cost is that final wealth will be lower, as the retiree is literally spending more of that excess wealth during retirement. Which, of course, is the whole point!
A DOMINATING STRATEGY
Actually, the ratchet approach increases spending at least once in almost all historical scenarios; a ratchet does not occur only when a highly adverse sequence of returns occurred early on and the portfolio barely had enough money to last for 30 years in the first place.
The purpose of the 4% rule is to set spending low enough that even if an adverse event occurs, spending can be maintained.
In the world of game theory, a strategy achieves dominance over alternatives when it provides superior outcomes in all situations. In the context of safe withdrawal rates, the ratcheting 4% rule can be called a weakly dominant strategy over the traditional approach; while the lifetime spending outcomes are not always better, they usually are and they are never worse. Because the spending floor moves upward when it is safe to do so, it is never triggered when that could lead to a more-rapid depletion of assets.
Notably, the idea of dynamic spending strategies as opposed to just using safe withdrawal rates as a blind autopilot program that is never adjusted is actually not new.
Financial planner Jon Guyton of Cornerstone Wealth Advisors in Edina, Minn., did a series of studies in 2004 and 2006 applying what he called the capital preservation and prosperity decision rules. The former was a rule that allowed for spending to be cut if withdrawals rose to be a dangerously high percentage of the portfolio (because spending growth was outpacing portfolio growth), while the latter was a rule that allowed spending to be increased if portfolio growth was especially favorable.
The ratcheting 4% rule is actually just a very simple approach to dynamic spending, one that sets initial spending at level that is conservative enough to avoid the need for cuts, but leaves room for raises.
And while it dominates the outcomes of the traditional safe withdrawal rates approach, there is clearly still room for further research about even better ways to apply ratchet thresholds. For instance, given that some 4% scenarios result in truly extraordinary excess wealth for example, when a person retires on the eve of a significant bull market it may be feasible to apply a second threshold, perhaps more than 200% of initial wealth, where even greater spending increases can be applied.
In the meantime, given the higher lifetime spending supported by the ratcheting 4% rule, it is arguably a better baseline than the traditional 4% rule against which all future retirement research should be compared.
Michael Kitces, CFP, is a Financial Planning contributing writer and a partner and director of research at Pinnacle Advisory Group in Columbia, Md. Hes also publisher of the planning industry blog Nerds Eye View. Follow him on Twitter at @MichaelKitces.
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