4% Rule Is Based on Faulty Assumptions, New Paper Argues

"The experience of U.S. investors [between 1926 and 1991] does not mirror that of investors in many other developed markets," the paper states. "For example, although long-horizon equity market losses are rare or nonexistent in the U.S., Japan's stock market suffered a nominal return of -9% over the recent 30-year period from 1990 to 2019."

In short, the analysis posits, the historical record of asset-class performance in the U.S. used to develop the 4% rule likely offers a poor reflection of the forward-looking return distribution.

The new analysis seeks to address these concerns by using a comprehensive dataset of real returns for domestic equity, international equity, government bonds and government bills in developed economies. The data cover approximately 2,500 total years of asset-class returns in 38 developed countries over the period from 1890 to 2019.

"As such, our evaluation of the 4% rule and its alternatives better reflects the ex ante uncertainty faced by current and future retirees," the researchers state.

Ultimately, the researchers find the 4% rule proves "woefully inadequate" for current retirees. Specifically, a retired couple faces a 17.4% probability of financial ruin — i.e., depletion of financial wealth prior to death — using the 4% rule.

"Given the poor performance of the 4% rule, we explore alternative constant real withdrawal policies," the paper states. "Our findings suggest that most retirees (i.e., retirees with relatively modest levels of wealth) cannot achieve a reasonable standard of living while maintaining a very low ruin probability."

To achieve a 1% ruin probability, for example, retirees must adopt a withdrawal rate of just 0.80%, or just $8,000 of withdrawals per year for $1 million in savings. When they attempt to balance the desires to achieve a higher standard of living and to avoid financial ruin, the researchers find that a retired couple willing to bear a 5% ruin probability may withdraw 2.26% per year.

This value is considerably lower than those proposed in prior studies, and it is just over half of the 4.22% rate implied by the post-1925 U.S. data.

Advisor Interpretations

Asked to interpret these numbers from the perspective of a financial advisor working with retired clients, Kelly Wright, director of financial planning at Verdence Capital Advisors, says they are eye-opening. However, he wonders whether they are informative from a practical perspective.

"Given the late-September dividend rate of the S&P 500 was about 1.7%, and the long-term rate is higher, a 'safe' withdrawal rate of 1.5% to 2.5% seems somewhat conservative," Wright says. "Although the dividend yield rate of the S&P 500 is about 1.5% this decade so far, that means that capital gains of only 2.5% allows for a total return of 4%."

Harman Johal, a U.S. Bank private wealth management market leader, says the determination of a given client's withdrawal percentage from a retirement account must consider many factors.

"A static rate of withdrawal may either deplete your retirement account too soon or may leave more assets than you intended to," he points out. "When you are determining a spending goal from your retirement accounts, a financial plan can take into consideration factors such as your current and future portfolio allocations, any big expenses you foresee, health care related costs and appropriate inflation numbers, among other factors."

Johal encourages clients to update their financial plan annually so that they can adjust their withdrawal rate if there's excess volatility in the markets or other emerging challenges.

"Our advice to clients is based on a planning-based approach," he emphasizes. "We take a deep dive to understand clients' goals and objectives to create a financial plan. We are able to help clients identify if they need to wait a few years to retire or withdraw less than they expected to, so they don't run out of money in their later retirement years."

Jay Zigmont, founder and childfree wealth specialist at Childfree Wealth, emphasizes that no two clients have the same outlook regarding the future, meaning that universal rules of thumb, whether they pertain to spending or saving, are not necessarily useful in practice.

"Many of the clients who I work with are not planning on a complete exit from the workforce such that they will need to survive on portfolio withdrawals alone for 30 years," Zigmont notes. "The evolving definition of retirement is an important consideration when creating an income plan."