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The 5 Flaws of Using the 4% Spending Rule in Retirement

September 21, 2022 | By Eric Siss, CFP®
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You've put a great deal of effort into saving for retirement, and now you're ready to cash in. But wait, you need to determine how much you can consistently withdraw from your savings. Spending beyond your means can leave you with insufficient funds in your “golden years” and spending too little means you sacrificed doing things that you would have enjoyed.

So how can you strike the right balance?

For decades, many retirees have looked to the 4% rule.

Should retirees still believe in this time-honored strategy? To put it simply: no

What Is the 4% Rule?

The 4% rule gained popularity because it is viewed as a way to estimate your annual retirement spending level that does not risk running out of money. The process is straightforward: You multiply 4% by your total investments during your first year of retirement. The dollar amount you withdraw is subject to annual adjustments for inflation in subsequent years.

For example, if you had $2,000,000 in portfolio assets, the 4% rule states that you withdraw $80,000 in the first year of your retirement. If inflation for that year was 2%, then your distribution amount for the following year would be $81,600. The 4% rule suggests that a retiree who anticipates living 30 years in retirement should be safe (i.e., they will have money left over at death) if they stick to the inflation adjusted 4% calculation, provided the retirement funds are invested in a 60/40 split between equities and fixed-income securities.

While this sounds simple, the key is knowing how to apply the rule to your unique circumstances.

What Are the Flaws with the 4% Rule Analysis?

1. The 4% Model Isn’t Flexible

An individual’s spending habits fluctuate from year to year. Consider large one-time costs associated with events like weddings, anniversary celebrations, long put off vacations, etc. These expenditures may mean that you are spending beyond the allotted 4% in one year and below in another. Once you are “off course”, it can be difficult to determine if you are still considered to be on a good trajectory.

2. The 4% Model Doesn’t Always Meet Your Needs

One of the 4% rule’s significant drawbacks is that it was developed for retirees with a 30-year lifespan in retirement. It would have different implications for a healthy 55-year-old retiree and a 75-year-old retiree with health issues.

With that in mind, it is essential to consider your potential longevity and keep in mind the average life expectancy has been rising over time.

3. The Start Date Matters a Great Deal

If a retiree had chosen to calculate their retirement distribution in March 2020 rather than on January 1 of that year, the 4% calculated withdrawal would have been drastically different. The same can be said if you anticipate a large sum of money in the future from downsizing your home or selling a business. The rule can occasionally be too simple to account for unexpected changes in portfolio values.

4. It Doesn’t Factor in Taxes

The rule does not account separately for taxes, and most people are not good at estimating their tax liability in retirement. Suppose you have all your money in Traditional IRAs, which are taxed at ordinary income rates upon withdrawal, vs. all your money in Roth IRAs, which are not taxed upon eligible withdrawals. In that case, the spending rate may look the same but buys a very different quality of life.

5. It Doesn’t Account for High-/Low-Risk Portfolios

The 4% analysis uses a middle-of-the-road portfolio. It doesn’t consider either low-risk or high-risk investment strategies. An under-diversified portfolio — for example, one with only a few individual stocks and no bonds — may be unable to sustain the 4% withdrawal rate if those companies significantly underperform or go out of business.

If you’re a conservative investor who only wants to put money in the safest bonds and CDs, your returns might not be high enough to cover your annual withdrawals of 4%.

The flip side is that the retiree may have been able to spend more than what the 4% rule allowed (sometimes significantly).

What to Do Instead?

We advise you to use a more effective tool, such as a Monte Carlo analysis, instead of the 4% rule.

Monte Carlo, like the 4% rule, analyzes past market scenarios, but it does so using a portfolio that is more closely aligned with the retiree’s actual holdings. It calculates the probability that an investor would have had sufficient funds under one thousand hypothetical market conditions (including some very favorable and some very unfavorable simulations).

The first step is to make reasonable predictions about your retirement age, lifespan, spending habits, and inflation rate. The analysis should also factor in anticipated windfalls, large one-time expenses, and taxes. Once this information has been gathered, the analysis is run to see how your ability to meet your goals would fare under the various market scenarios described above.

After a “base case” has been established, you can then see the effects of changing your assumptions (such as retiring earlier or spending more) on your financial plan.

Monte Carlo can, and should, be updated often in retirement to ensure you are following a sustainable path in retirement.

Bottom Line

Even if you withdraw less than 4%, the 4% rule does not guarantee that you will have enough money to live comfortably until your death. Nor does it suggest that you will go bankrupt if you take more than 4%.

Does that mean that we can forget about the 4% rule now? Not if you recognize its limitations and use it as a barometer, a measuring stick, or a starting point. There are, however, much better tools available, such as a Monte Carlo analysis. To feel secure about your retirement plan, work with a financial advisor who can help you adapt to the ever-shifting landscape of your financial goals and the financial markets.

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