The 4% rule - a bizarre way to retire?
Image Credit - Xan Griffin @xangriffin
Imagine you were sitting down with a financial planner discussing your retirement and the conversation drifted to spending strategies. Talk turns to typical ways to manage the extremely hard-earned nest egg you have worked to build up over your life and you mention you've heard about the 4% rule and if that perhaps was appropriate to consider as a roadmap for you drawing down on your funds? Firstly, the basics:
The 4% rule is a quite famous retirement income rule created by Bill Bengen. It states that based on historical data an investor can draw down 4% on their initial investment while adjusting the initial withdrawals for inflation without running out of money.
It is based on the US market (so a more global portfolio may have different results).
It does not factor in any charges that may be applied and with investing.
It is based on an underlying portfolio of 50% stocks and 50% bonds.
It assumes a 30-year retirement horizon - people who are trying to use this to achieve 'FIRE' - (Financial Independence Retire Early) should take note.
Now, this is historically and mathematically as a rule, extremely robust. Bill Bengen was quite literally a rocket scientist and the excellent book by Abraham Okusanya called - 'Beyond the 4% rule' dives into this in more detail. In fact, Bengen has also come out recently and started advocating for 'the 5% rule.' There is however a striking problem that has nothing to do with the excellent academic backing of this rule.
So you agree the 4% rule sounds interesting. You like the idea of a 'hard and fast rule and it gives you a sense of comfort. At the end of the day, you just want to make sure you have a happy retirement and the simplicity sounds appealing. Your financial planner agrees this is a good structure to work to but mentions that if the rule means anything, it has to be strictly maintained. Otherwise, there is simply no point relying on it as a framework. So now let's imagine a few scenarios:
Scenario 1 - The market doubles in value in the first 2 years
You can't believe the incredible run the market has had. You are so far ahead of where you expected you to be based on the initial plans you are now understandably thinking. - "There are so many things I haven't done that I could do now. There's that place on holiday that I could now go back to." You also mention that perhaps helping get your kids onto the property ladder would be nice. After all, how satisfying it is it to gift to a 'cold hand' instead of a 'warm one'? Nothing extravagant of course, just a few things that are reasonable to consider based on how far ahead you are compared to where you thought you'd be 2 years ago.
You sit down and have your meeting and you explain to the financial planner who, of course, says stone-faced it's a no. They say this is not in line with the plan set out at the outset and part of the 4% rule is not that you adjust when things look considerably more rosey than expected. It would completely throw out the framework if you start withdrawing 6% or 10% of that initial investment. It's the 4% rule, not the 4% (but adjust if things are ok for some years).
Scenario 2 - The market halves in value in the first 2 years
You, like everyone else is devastated at the drop not seen in a century. This makes you feel extremely nervous. You knew there would be ups and downs but seeing the value of your investments drop in this way and this speed has made you completely re-assess. The economy is completely shocking at the time. Holidays certainly are going to have to be cut back on. Perhaps some of the 'bucket list' things are seeming a tad unrealistic until the market comes back. You don't want to make a bad situation worse.
You again sit down and have your meeting with your adviser. You discuss all the various options where you can make minor adjustments. In many ways, you'd be glad to make them as it would give you a bit of peace of mind until the market recovers.
The adviser, yet again, says that is not the plan we agreed to. Stating you have committed to this strategy and you should rely on the data. You've tied yourself to the mast of backtesting and unless you want to break the initial strategy. You are going to ride the waves, or go down with the ship.
Do these answers work for you?
Now I appreciate, this is a bit exaggerated but I do think this is important to understand when considering what is on the table here. Plans by themselves can be worthless but planning as a process is absolutely everything. I have seen these hundreds if not thousands of times now, a well-placed change and a well-monitored plan can be the difference between having the retirement you've worked for, or not. However, let's not forget a historical record of performance does not provide certainty for the future.
Nobel Laureate - William Sharpe referred to retirement income as:
"The nastiest, hardest problem in retirement."
While it would be very convenient to be able to water down retirement income to a simple rule. If we try to reduce this problem to this we are deluding ourselves on the nature of ourselves and our position. While I am a big fan of statistical modelling and it really does have its place. We cannot let that deceive us into thinking here that a simple rule can answer a complex problem.
For a decision and strategy which combines the endless variation of a person's financial and personal circumstances developing over a 30-year+ retirement. In combination with the ever-changing investment and economic landscape. As much as it would make things easier to have a simple answer I strongly feel the truth is there is just no substitute with a structured and realistic approach, ideally mapping things out carefully with a professional who you trust who can help you through this. Regardless of the data, any strategy over this timeframe that is based on a simple rule will always miss the fact that even if the plan doesn't change, you most certainly will.
