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In this series, we provide our readers with two distinct perspectives on the same topic — one from an academic, the other from a practicing financial advisor.
If you have a question or two, please send them to us. Check out the previous column here.
QUESTION: Is the 4% rule dead?
THE ADVISOR — JOE ELSASSER, CFP, PRESIDENT, COVISUM:
The 4% rule is not a rule at all, unless you mean rule of thumb. There have been other "rules" based on similar ideas. Famed portfolio manager Peter Lynch of the Fidelity Magellan Fund famously published a 7% "rule" in his 1995 article entitled "Fear of Crashing." His argument was that stocks dramatically outperform bonds over time, so an all-stock portfolio, based on stocks with an average dividend yield of 3% and 8% return from capital gains would grow from $100,000 to almost $350,000 after 20 years, and would even survive a 25% crash, with an ending value of approximately $185,000.
Lynch's argument, which represented much of the feeling of the time, was challenged by Bill Bengen, who is now known as the father of the 4% rule. Bengen changed the discussion by arguing first that a 20-year retirement period was not enough, extending his analysis to 30 years. Bengen used rolling 30-year periods, actual market returns and actual inflation to identify 4% as a safe withdrawal rate. His results showed that if you began drawing on a portfolio on the worst possible day in history and continue withdrawing an inflation-adjusted amount every year for 30 years, 4% was the highest amount you could sustain while still having money left at the end of the 30-year period. He called this withdrawal rate the Safemax.
In short, Bengen's process for arriving at 4% was considerably more robust and used better assumptions than Lynch's. As a result, it yielded a much lower safe withdrawal rate. Funny enough, Lynch's rule was pretty close to a 4% rule, but he assumed that a 3% and growing dividend would always be present.
Now, the 4% is being challenged on all sides, in roughly the same way Bengen challenged Lynch and the prevailing "wisdom" of the day. Bengen chose a 30-year period, but life expectancy has been consistently increasing. Bengen used U.S. stock returns. Is that a fair assumption? Is it likely that the next 30 or 40 years of U.S. returns will parallel our economic history in which stocks climbed from 22% of the world's total market capitalization to 54%? 1
