This is the second in a new series of columns about Social Security and retirement income planning.
The problem with so-called "safe" fixed withdrawal rules for retirement spending, including the famous 4% rule, is that the underlying assumptions are woefully out of date, and top planning experts say the time has come to consign these rigid strategies to the dustbin of history.
In their stead, fiinancial advisors can lean on modern planning techniques and technologies that deliver a far more flexible and responsive approach to retirement income, including the increasingly popular guardrails framework.
The simple truth is that people today tend to live much longer in retirement than they did 30 years ago when the 4% rule was first tabulated, and empirical data shows retirement spending fluctuates a lot based on people's real-world needs. Still, the 4% rule remains ubiquitous in the popular media, and it is even recommended by some financial advisors.
Unfortunately, such advisors may be steering their clients toward the dreaded retirement income death spiral, which is the inevitable result of at-risk clients failing to carefully monitor the effect of annual spending or market drops on their overall financial plan. Advisors who use the 4% rule might also be causing wealthy clients to significantly underspend when there are no big legacy goals to fund.
By embracing the concept of retirement income guardrails and dynamic spending frameworks — potentially to be complemented by the shrewd addition of annuities to the portfolio — advisors can help their clients spend in a truly safe manner while meeting their lifestyle goals.
Why the 4% Rule Doesn't Work Anymore
The 4% rule suggests a given client in retirement should add up all of their investments and simply plan to withdraw 4% of their total wealth during their first year of retirement. The withdrawal amount is then adjusted annually to account for inflation.
The approach is attractive for its simplicity and its alleged safety, but as Wade Pfau, principal and director at McLean Asset Management and RISA LLC, recently told me, there is good reason to have concerns about the reliability of the rule in the current market environment.
Echoing the insights of researchers and planning experts including PGIM's David Blanchett and Michael Finke at The American College of Financial Services, Pfau says the very low inflation rate seen in recent years was the artificial saving grace behind this rule of thumb. The outlook has now changed with substantially higher inflation, longer client lifespans and lower long-term capital market return assumptions.
As Finke emphasizes, the 4% rule originates from a single 1994 analysis published by William Bengen, whose work suggested that a retirement strategy with 50% in U.S. stocks and 50% in government bonds would have survived each 30-year period in the U.S. historical record from 1926 to 1991 with inflation adjusted annual withdrawals starting at about 4%.
Since that time, however, there have been some big changes in the marketplace, Finke says. Simply put, the United States enjoyed a uniquely strong period for returns in the 20th century that was used as the basis for Bengen's research, and it may no longer be valid going forward.
There's also the fact that the U.S. is seeing rapid longevity increases that go beyond the assumptions baked into the 4% withdrawal rule. This is especially true for the top 10% of income earners, Finke notes, who tend to be advisors' best clients.
"We have seen six additional years of longevity for men in just the last two decades," Finke says. "For a healthy couple retiring at 65 today, some 50% of them will see at least one spouse live beyond 95 — the maximum age considered in the original 4% rule research."
Are Income Guardrails the Answer?
Among the financial planning luminaries consistently advocating for a better income planning approach is Jamie Hopkins of Bryn Mawr Trust. According to Hopkins and others, a better strategy is to constantly monitor and regularly adjust spending (up or down) during retirement.
