This article builds on a previous piece about sequencing risk and how it can negatively impact retirement outcomes. Various strategies have been proposed to mitigate sequencing risk and broader market risk when drawing down assets in retirement. Among them, the 4% rule is perhaps the most well-known, and the most debated.
The 4% rule suggests that retirees can safely withdraw 4% of their portfolio in the first year of retirement, then adjust that amount annually for inflation, with a high probability of not outliving their savings over a 30-year period. In reverse, this implies that to retire, one would need investments totalling 25 times their desired annual income.
This method of calculating retirement is very popular due to its simplicity and basis in research and data analysis. It also has its detractors though, ironically some that believe it is too conservative and others who believe it is far too optimistic.
So, what is the basis for the 4% rule and what are some of the critiques applied to it?
The Trinity Study – The Basis for the 4% Rule
The 4% rule is a widely referenced guideline in retirement planning. This rule is based on the Trinity Study, a well-known academic analysis of sustainable withdrawal rates.
The concept originated from the work of financial planner William (Bill) Bengen in 1994, who introduced the idea of 4% being a safe withdrawal rate after analysing historical market data. He identified that one of the biggest risks for retirees is Sequencing Risk: the impact that the timing of market returns has on a portfolio when withdrawals are made. He showed that while the stock market delivers positive long-term average returns, the timing of negative returns in the early years of retirement can significantly increase the risk of a portfolio extinguishing before the retiree’s lifetime ends.
Building on Bengen’s research, three professors from Trinity University: Philip Cooley, Carl Hubbard, and Daniel Walz conducted a more comprehensive study in 1998. The Trinity Study examined how different withdrawal rates and portfolio allocations affected the longevity of retirement savings. Their research was based on historical data from 1926 to 1995, analysing stock returns using the S&P 500 Index and bond returns using long term corporate bond indexes. The study focused on US market data and tested portfolios with different allocations to stocks and bonds.
To assess portfolio sustainability, the researchers simulated retirement scenarios by applying withdrawal rates ranging from 3% to 12% to various asset allocations over rolling 30-year periods.
The results showed that withdrawal rates above 5% significantly increased the likelihood of portfolio depletion, particularly for portfolios with a higher allocation to bonds. However, a 4% withdrawal rate had a success rate exceeding 90% when at least 50% of the portfolio was invested in stocks. In comparison, a 5% withdrawal rate with 50% in equities only had a 70% chance of success. This fell to 50% for a 6% withdrawal rate.
The study also found that the safest withdrawal strategy required maintaining at least 75% in equities, as lower stock allocations reduced the probability of sustaining withdrawals over time. However, the higher the allocation to equity, the greater the potential for sequencing risk.
Whilst a person saving for retirement benefits from market downturns (as they can buy investments at lower prices), the opposite is true for someone withdrawing from their portfolio. If a retiree experiences significant market losses in the early years of retirement, the portfolio may struggle to recover, increasing the risk of running out of money.
Overall, the Trinity Study reinforced the idea that retirees should be mindful of withdrawal rates, asset allocation, and market conditions. It also provided an empirical and data-driven justification for Bengen’s 4% safe withdrawal rate. A rule that continues in popularity today, nearly 30 years after the publishing of the Trinity study.
Criticism
Despite its popularity, the 4% rule still has a large number of detractors. Some of these criticisms are outlined below:
Too Optimistic
The 4% rule is often criticised for being overly optimistic as it relies on US market data, which may not reflect the average portfolio. The period studied included decades when the US was the dominant global economic power. The average Australian portfolio differs considerably, with different asset exposures and importantly, being subject to different economic influences like exchange rates. Applying a rule based on a potentially unique period of US market dominance may overlook the variability in returns across different economies and asset classes.
It also assumes a fixed withdrawal strategy which may cause issues in periods of high inflation or market downturns. Importantly, the incidence of future large downturns may not be at the same cadence as it was in the past. This adds much more sequencing risk if market volatility is higher on average.
Whilst the study makes clear a 4% withdrawal should be safe for a 30-year retirement, it’s not as if this timeframe is fixed when deciding to retire. Outliving this 30-year timeframe is considered longevity risk and may cause capital to be completely depleted. With increasing life expectancies, many retirees could live well beyond 30 years, especially those retiring in their late 50s and early 60s, or those with FIRE aspirations.
Lastly, with stock indices at historically high valuations, many pundits predict lower average returns for equities. They argue that company earnings cannot possibly grow enough to justify current prices, leading to weaker long-term performance. However, similar concerns have been raised for decades, often without materialising, so relying too heavily on these projections may be misguided.
Too Conservative
Ironically, there are also critiques of the 4% rule that centre on it being too conservative.
A key issue is that it assumes retirees rely solely on their investment portfolio for income, without factoring in other sources such as the Age Pension. Many retirees end up qualifying for at least a partial Age Pension at some point in their retirement. This naturally reduces pressure on a portfolio as being the sole income source. This additional income could allow for a higher withdrawal rate in earlier year as the assets are consumed, the eligibility for age pension could increase.
This is more related to a FIRE based retirement, but there is critique that the 4% rule does not account for taking on part time work during retirement. This could be used to buffer income in years of a market downturn, reducing the requirement to consume invested capital and thus lock in the loss of the investments.
Another limitation is the rule’s focus on investment portfolios consisting only of equities and bonds, without considering other assets such as property. Many Australians hold a significant portion of their wealth in real estate, which may provide rental income or be downsized to free up capital.
Some more recent studies also suggest that the 4% rule may be too conservative. Research examining historical market performance indicates that in many cases, retirees withdrawing at 4% end up with more wealth than they started with. A study covering 140 years of US market data found that retirees had only a 10% chance of running out of capital over 30 years, but a 10% chance of ending up with six times their original wealth. Some argue that a 5% withdrawal rate is more realistic, particularly for retirees who are not relying solely on their portfolio. This suggests that the 4% rule might cause retirees to underspend and leave behind more wealth than necessary.
Inflexibility
A major drawback of the 4% rule is its rigidity. It assumes a fixed withdrawal amount, adjusted only for inflation, regardless of market conditions or personal circumstances. This approach doesn’t account for periods of poor market performance, where reducing withdrawals could help preserve capital. In a severe downturn, sticking to a fixed withdrawal could accelerate portfolio depletion.
It also ignores the reality that spending needs often change in retirement. Retirees typically spend more in their early years and less as they age. Medical costs may rise later in life, but discretionary spending on travel and leisure often declines. A more flexible withdrawal strategy, such as adjusting spending based on market performance or personal needs can improve outcomes considerably.
By following a rigid rule, retirees risk either withdrawing too much during downturns or being overly conservative and leaving behind unspent wealth. A dynamic approach may better suit real-world retirement patterns.
Conclusion
Like any retirement planning framework, the 4% rule is imperfect. In some scenarios, it may be overly conservative, leading to an unnecessarily frugal retirement. In others, it can be dangerously optimistic, particularly for those who retire just before a major market downturn.
At its core, the 4% rule serves as a psychological strategy, helping to manage the inherent uncertainty of retirement. It does this by pointing to a historical success rate exceeding 90%. However, past market data is no guarantee of future outcomes. While it provides the best indication available, markets respond to ever-changing economic conditions that never perfectly mirror the past.
In most cases, the 4% rule is likely to be too conservative. A strategy designed for a 90% success rate means that, on average, retirees will end up with more wealth than they anticipated at the end of their lives. Whether this is desirable depends on individual risk tolerance and flexibility. Some retirees would prefer to prioritise financial security above all else, while others may prefer to spend more freely in their early retirement years, adjusting later if needed. After all, making it through 30 years of retirement is never guaranteed.
