The so-called 4% rule has been a widely used guideline since financial adviser Bill Bengen published his paper on the topic 30 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 having to worry about ever running out of money.
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But that rule “is blind to the new reality of what you experience as a retiree,” said Michael Finke, a professor of wealth management at the American College of Financial Services and a longtime critic of the 4% rule.
It overlooks the fact that nobody knows what investment returns will be in the future. It ignores a retiree’s ability to tweak spending in response to real-life market returns. And it disregards the fact that nobody knows how long retirement will last.
Spend more, live better
A more practical model, wrote Finke and Tamiko Toland in a recent paper, gives people the freedom to spend earlier in retirement because it allows for adjustments in spending based on prevailing conditions, including the portfolio value and individual longevity expectations.
In an interview, Finke provided this example to illustrate some of the shortcomings of the 4% rule for retirement withdrawals and promote the use of his and Toland’s model: If you have $1 million saved for retirement, the 4% rule suggests 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, nobody knows in advance what kind of investment returns they’re going to get,” said Finke, who along with Toland recently co-founded IncomePath, a retirement-income planning tool. “And that means that for some people, if they get a very good sequence of investment returns, they could probably have spent a lot more than $40,000. They probably could have spent $50,000 or maybe even $60,000 that first year of retirement.”
Essentially, Finke said, you’re adopting a conservative financial approach at the start of retirement to minimize the slight risk of running out of funds later.
Another critique of the 4% rule is this: No one who reaches the age of 90 and has only $150,000 left in savings will continue to spend $80,000 a year. “Nobody’s going to continue spending the same way that they did (during the early years of retirement),” said Finke. “So (the 4% rule) ignores the reality of human nature.”
One more problem: If you get 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 bit more, live better,” said Finke. “Because otherwise, you will get to a point where you’ve got so much money in surplus that you start asking yourself, ‘Do I really want to give this money to my kids, or do I actually want to spend it myself?’”
In short, the 4% rule just assumes you’re going to spend the same amount after inflation every year, that you’re going to have a fixed lifestyle. And it uses failure rates to evaluate investment choices. “It’s not realistic,” said Finke. “It’s not efficient.”
The 4% rule aims to minimize the risk of failure (running out of money) by being very conservative with spending early in retirement. However, this comes at the cost of potentially underutilizing one’s savings and not being able to spend more if investment returns are favorable.
If not the 4% rule, then what?
Some researchers have proposed ways to offset the limitations of the 4% rule. Some, for instance, have suggested using guardrails which allow you to increase or decrease your spending depending on market returns. But that strategy has shortcomings as well, said Finke.
Setting a lower limit or “guardrail” on how much you can reduce your spending during market downturns can actually increase the risk of running out of money prematurely. This is because it takes away your ability to be flexible and cut spending further if investment returns remain poor for an extended period. Locking in a minimum spending level prevents you from making the deeper cuts that may be needed to stretch your portfolio during prolonged bear markets. Likewise, imposing limits on the upside can hinder the potential for lifestyle improvement when investments perform well.
Finke is no fan of Monte Carlo simulations used by many financial planners.
“I hate the idea of going to see a financial adviser or using a financial software program and you are told that you can probably achieve this kind of a lifestyle, but there’s a 15% chance of failure,” he said. “It doesn’t give people any sort of a real understanding of what their lifestyle could 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 empowers people to choose a spending strategy best suited to their needs and that can be adjusted along the way that:
In essence, it’s an approach that incorporates life expectancy into the withdrawal calculation but also has the objective of maintaining stable income throughout retirement; it enables a person to select the right combination of investment risk, portfolio withdrawals and annuity income. An annuity is a contract in 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 features an adaptive withdrawal strategy that recalculates the withdrawal every year based on the account value and the expected lifespan of the individual. In addition, when it’s available for commercial use, the software allows a withdrawal adjustment that permits spending flexibility up to a stated percentage of the previous year’s withdrawal.
“The question that retirees seek to answer is ultimately less about income than it is about lifestyle,” wrote Finke and Toland.
“When you take investment risk, there’s a range of different lifestyles that you could have,” said 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, how much they want to spend initially, and also, whether or not they want to add an annuity to the mix when they’re creating a retirement income plan.”
Why this approach? For one, the annuity can be used to mitigate and manage longevity risk. “We believe that longevity risk is what’s known as an idiosyncratic risk,” said Finke. “And you get no benefit for accepting an idiosyncratic risk. I don’t live better for accepting longevity risk. But if I can transfer that risk to an institution like an insurance company, then I can spend more every year and I don’t have to worry as much about potentially running 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 income 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, say, bonds. Based on search results using Perplexity.ai, if you invest $400,000 in a single premium immediate annuity at age 65, you can expect to receive an annual income of around $31,720. By contrast, investing $400,000 in a 30-year government bond would provide an annual income of around $19,000, while a 30-year high-quality corporate bond would provide a slightly higher annual income of around $22,000.
“So, you get to cover more of your income goal by taking a portion of your savings and buying an annuity, which actually means you take less money out of the remainder of your investment portfolio,” said Finke. “And that can actually grow over time. So one of the things that it illustrates is that the upside is actually greater when you take a portion of your savings and turn it into an annuity.”
That is likely news for many financial advisers and consumers who have not really considered the benefit of the annuity. “It’s not just downside protection,” he said. “But also the ability to live better in the future because it puts less pressure on the remainder of your investment portfolio.”
It’s important to understand how increasing how much is invested in an annuity influences your current lifestyle, as well as your financial situation 20 and 30 years from now, Finke said. “Because you’re offloading that idiosyncratic longevity risk to an institution, you can spend more at every age.”
Using this goals-based process also eliminates the need to show Monte Carlo results, which focuses on failure, the percent chance that your plan will fail to fund your desired standard of living. “Failure is not part of the equation, but lifestyle is all of the conversation,” said Finke. “What is the range of potential lifestyles that you could have?”
Finke also believes retirees should be able to evaluate potential income paths where spending will decline on a real basis over the course of retirement. “They should decide if they want to live better in their late 60s and 70s when you do have the physical capabilities and the cognitive capabilities to enjoy your life more…And in reality, it does appear that people do spend it less as they get older,” Finke said.
Many retirees and financial advisers are reluctant to use annuities as part of a retirement income plan. How does Finke propose to persuade retirees and financial advisers to consider using such products?
He tells individuals to consider the amount they wish to allocate from their retirement wealth for inheritance purposes and the amount they intend to use for their own lifestyle expenses. By making a conscious decision in this regard, he said it becomes more comfortable to justify using a part of your savings to purchase lifelong income, especially when that specific portion of your savings is earmarked for this exact purpose.
Of course, finding a financial adviser who might be willing and able to implement a retirement income plan that includes an annuity may not be easy. Many don’t have the knowledge, skills or abilities to do so. Others might not have the appropriate license to sell such products. And it’s also hard to find someone you can trust. And that places a huge burden on the individual to search far and wide for the right adviser.
“I am a big fan of using as many tools as you have available to solve the problem, putting together a plan that allows the client to achieve the lifestyle that they really want to achieve,” said Finke. “And in many cases, they can only get that security by using a blend of different strategies.”
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