The so-called 4% rule has been a widely used guideline since financial advisor Bill Bengen published his article on this subject thirty years ago.
The 4% rule suggests that retirees can safely withdraw 4% of their portfolio in the first year of retirement and then adjust that amount annually for inflation over the course of at least 30 years without worrying that they will ever run out of money.
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But that rule “is blind to the new reality of what you experience as a retiree,” says Michael Finke, a professor of asset management at the American College of Financial Services and a longtime critic of the 4% rule.
It ignores the fact that no one knows what investment returns will be in the future. It ignores a retiree’s ability to adjust spending in response to real market returns. And it ignores the fact that no one knows how long retirement will last.
Spend more, live better
A more practical model, Finke and Tamiko Toland wrote in a recent article, gives people the freedom to retire earlier because it allows adjustments in spending based on prevailing circumstances, including portfolio value and individual longevity expectations.
In an interview, Finke gave this example to illustrate some of the shortcomings of the 4% rule for retirement withdrawals and to promote the use of his and Toland’s model: If you have $1 million saved for retirement, the 4% rule suggests that you can withdraw $40,000. (4% of $1 million) in the first year. In subsequent years, you can increase your withdrawal amount to account for inflation without depleting your retirement savings too quickly.
“But of course no one knows in advance what kind of investment return they will get,” says Finke, who recently co-founded IncomePath, a retirement income planning tool, with Toland. “And that means that for some people, if they got a very good set of investment returns, they probably could have spent a lot more than $40,000. They probably could have spent $50,000 or maybe even $60,000 that first year after retirement.”
Essentially, Finke said, take a conservative financial approach at the beginning of your retirement to minimize the small risk of running out of money later.
Another criticism of the 4% rule is this: no one who reaches age 90 with only $150,000 left in savings will continue to spend $80,000 per year. “No one is going to continue to spend the same way they do (during the early years of retirement),” Finke said. “So (the 4% rule) ignores the reality of human nature.”
Read: Americans’ spending consistently declines after age 65; Finding applies broadly to all asset groups.
Another problem: If you’re lucky and your investment returns are higher than you expected, you should be rewarded for taking that investment risk. “You should be able to spend a little more and live better,” Finke said. ‘Because otherwise you get to a point where you have so much money left that you start asking yourself, ‘Do I really want to give this money to my children, or do I actually want to spend it myself?’ ”
In short, the 4% rule assumes that you will spend the same amount every year after inflation, that you will lead a fixed lifestyle. And it uses failure rates to evaluate investment choices. “It’s not realistic,” Finke said. “It’s not efficient.”
The 4% rule aims to minimize the risk of failure (running out of money) by being very conservative with early retirement expenses. However, this comes at the cost of potentially underutilizing one’s savings and not being able to spend more when investment returns are favorable.
If the 4% rule does not apply, what then?
Some researchers have suggested ways to compensate for the limitations of the 4% rule. For example, some have suggested using guardrails that allow you to increase or decrease your expenses depending on market returns. But that strategy also has shortcomings, according to Finke.
Setting a lower limit or “guardrail” on how much you can reduce your spending during market downturns can increase the risk of running out of money prematurely. This is because it takes away your ability to be flexible and make further cuts if investment returns remain poor for an extended period of time. By setting a minimum spending level, you can avoid making the deeper cuts that may be necessary to stretch your portfolio during extended bear markets. Likewise, imposing limits on the upside can hinder the potential for lifestyle improvement when investments perform well.
Finke is not a fan of Monte Carlo simulations used by many financial planners.
“I hate the idea of going to a financial advisor or using a financial software program and being told that you can probably achieve such a lifestyle, but there is a 15% chance of failure,” he said. “It doesn’t give people any real insight into what their lifestyle might look like.”
In practice, every retiree should be able to adjust their spending if markets perform poorly, perform better than expected, or if their health or personal circumstances change, Finke noted.
Managing ‘idiosyncratic risk’
So instead of the 4% rule, Finke favors a different approach that allows people to choose a spending strategy that best suits their needs and can be adjusted as they go:
Essentially, it is an approach that incorporates life expectancy into the withdrawal calculation, but also aims to maintain a stable income throughout retirement; it allows one to select the right combination of investment risk, portfolio withdrawals, and annuity income. An annuity is a contract under which an insurance company agrees to pay an income for life or for a specified number of years.
In their paper, Finke and Toland say this new approach includes an adaptive withdrawal strategy that recalculates withdrawals each year based on the account value and the individual’s expected lifespan. Additionally, when the software is available for commercial use, it allows for a withdrawal adjustment that allows spending flexibility up to a certain percentage of the previous year’s withdrawal.
“The question retirees are trying to answer is ultimately less about income than about lifestyle,” Finke and Toland wrote.
“When you take investment risks, you can have a whole range of different lifestyles,” says Finke. “I think it’s much better to be able to show people what that range of lifestyles looks like when they’re making decisions about how much investment risk they want to take on, how much they want to spend initially, and also whether or not they want to spend. want to add an annuity to the mix when creating a retirement income plan.
Why this approach? First, the annuity can be used to limit and manage longevity risk. “We believe that longevity risk is an idiosyncratic risk,” says Finke. “And you get no benefit from accepting an idiosyncratic risk. I don’t live better because I accept the longevity risk. But if I can transfer that risk to an institution like an insurance company, then I can spend more every year and have less fear that I might run out of money.”
Finke gave this example of the power of adding an annuity to a retirement income plan: Let’s say you have $1 million and an initial income goal of $50,000. You take 30% or 40% of your savings and use it to buy an annuity. That income annuity will be able to provide more income toward that $50,000 spending goal than if you had kept the money in bonds, for example. Based on the search results on Perplexity.ai, if you invest $400,000 in a one-time immediate premium at age 65, you can expect an annual income of approximately $31,720. In contrast, investing $400,000 in a 30-year government bond would yield an annual income of about $19,000, while a high-quality 30-year corporate bond would yield a slightly higher annual income of about $22,000.
“So you can cover more of your income goal by taking some of your savings and buying an annuity, which essentially means you’re taking less money out of the rest of your investment portfolio,” says Finke. “And that can even grow over time. One of the things it illustrates is that the benefit is actually greater if you convert part of your savings into an annuity.”
That’s probably news to many financial advisors and consumers who haven’t really thought about the benefit of the annuity. “It’s not just about downside protection,” he said. “But also the opportunity to live better in the future, because it puts less pressure on the rest of your investment portfolio.”
It’s important to understand how increasing the amount invested in an annuity affects your current lifestyle, as well as your financial situation 20 and 30 years from now, Finke said. “Because you transfer that idiosyncratic longevity risk to an institution, you can spend more at any age.”
Using this goal-based process also eliminates the need to show Monte Carlo results, which focus on failure, the percentage chance that your plan will fail to fund your desired standard of living. “Failure is not part of the equation, but lifestyle is the whole conversation,” Finke said. “What are the possible lifestyles you could have?”
Finke also believes that retirees should be able to assess potential income trajectories where expenses will decline on a real basis over the course of retirement. “They should decide whether they want to live better in their late 60s and 70s, when you have the physical and cognitive capabilities to enjoy your life more… And in reality, it seems that people spend less as they get older Finke said.
Many retirees and financial advisors are reluctant to use annuities as part of a retirement income plan. How does Finke plan to convince retirees and financial advisors to use such products?
He tells people to think about the amount they want to spend from their retirement assets for inheritance purposes and the amount they want to use for their own lifestyle costs. By making a conscious decision in this regard, he says it will become more comfortable to justify using a portion of your savings to purchase lifetime income, especially if that specific portion of your savings is earmarked for this specific purpose.
Of course, finding a financial advisor willing and able to implement a retirement income plan that includes an annuity may not be easy. Many do not have the knowledge, skills or abilities to do this. Others may not be properly licensed to sell such products. And it’s also hard to find someone you can trust. And that puts a huge burden on the individual to search far and wide for the right advisor.
“I’m a big believer in using as many tools at your disposal to solve the problem, putting together a plan that will help the client achieve the lifestyle he/she really wants to achieve,” said Finke. “And in many cases, they can only achieve that certainty by using a combination of different strategies.”
