When Bill Bengen published “Determining Withdrawal Rates Using Historical Data” in the October 1994 Journal of Financial Planning, common practice was to plan retirement spending based on an average return. If the portfolio averaged 7% and inflation averaged 3%, you could spend 4% forever. Bengen showed that this was wrong because the order of the returns mattered. A retiree who encounters a bad sequence of returns can run out of money with this strategy.

Bengen’s critique of the state of the practice at that time was correct, but the so-called 4% rule that came out of Bengen’s paper is a different matter. I don’t use it, and I don’t even use it as a first-order approximation. This Field Note explains why I believe the retirement planning world would be better off if we completely ignored the 4% rule.

A furnace with no thermostat

Let’s start with what the 4% rule actually says. The 4% rule does not say, “withdraw 4% of your portfolio each year.” It says: withdraw 4% of your balance in the first year of retirement, then raise that amount by the rate of inflation each year, no matter what the portfolio does.

Suppose you begin retirement with a $3 million portfolio. The 4% rule says that portfolio will support $120,000 in year one. Suppose inflation that year was 3.33%. In year two, the rule says you will spend $124,000. If the market falls 30%, you spend $124,000. If it doubles, you still spend $124,000.

If inflation in year two is 3.2%, in year three, the 4% rule says you will spend $128,000. It doesn’t matter if the market falls another 20%, you still increase spending each year.

My electrical engineering friends use the phrase open loop–which refers to a system running with no feedback. It’s like leaving your furnace set to turn on 30 minutes every hour no matter how warm or cold your house is. That plan might work some of the time, but most of the time your house will be either too warm or too cold.

Withdrawals do not equal spending

The 4% rule seems to assume that household spending can be modeled by the amount that’s withdrawn from a portfolio, but this is not even approximately correct.

The withdrawal amount needed varies significantly over the life of a household. One spouse might retire a few years before the other spouse does. The household might be fine withdrawing less than 4% from their portfolio during those years, or it might not need to withdraw anything at all.

One spouse might begin claiming Social Security at 62 and the other at 70. The withdrawal amount needed to support the household will be one amount before social security begins, a second amount while only one spouse is claiming benefits, and a third amount after both are claiming benefits.

Older households will often pay off their mortgage. The spending need after the mortgage is paid off is not the same as the spending need earlier.

Most households also experience one-off major expenses such as paying for a wedding or a vacation home.

Some households also experience cash inflows, via sale of a first or second home or receipt of an inheritance.

Role of specific investments. Bengen’s 4% rule was based on a portfolio that was comprised of 50% S&P 500, 50% intermediate-term Treasuries. If we accepted the rule as an approximation at all, it would only be applicable to households with that particular allocation. Bengen’s paper is actually pretty good about clarifying that the rule would be different with a 75/25 mix, but that nuance gets lost in most discussions about the 4% rule.

Role of taxes. Finally, the 4% rule ignores the effect of taxes on withdrawals. For a 4% withdrawn from an IRA account, the entire withdrawal will be taxed as ordinary income. For a 4% withdrawal from a taxable account, the withdrawal may be taxed as capital gains, and only on the gains portion. A 4% withdrawal from a Roth account will not be taxed at all.

Bengen’s study covered withdrawal periods beginning from 1926-1976. He assumed all money was being withdrawn from tax-deferred accounts. During that period, the lowest marginal tax rates varied from 0.375% in 1929 to 23% in 1944-1945. The highest marginal tax rates varied from 24% in 1929 to 94% in 1944-1945.¹ Withdrawing a “constant amount adjusted for inflation” would hardly have been a constant amount after taxes through those widely varying tax regimes.

Households’ first concern is the amount they can spend. Even if spending is held constant, the amount that needs to be withdrawn to support constant spending will vary significantly because of variations in taxes and in the other resources available.

Example of realistic lifetime withdrawal rates

Here’s an example of a meaningful life-time withdrawal projection that illustrates some of the real-world dynamics that can affect withdrawal rates. Withdrawal rates vary significantly depending on the household’s circumstances each year.

These projected withdrawal rates are for a household with one specific set of circumstances, goals, and investments. The withdrawal rates for this household vary significantly, peak at full retirement and generally decline after that. The withdrawal rate averages about 4%, but that’s driven by the fact this household has ample assets relative to its spending needs. With different circumstances, goals, and investments, a different household could easily average 5% or higher, and spending could increase in later retirement years. But what never changes is that year-to-year percentages fluctuate a lot.

A better response to sequence of returns

A low, fixed-percentage withdrawal rate is a crude way to mitigate sequence-of-returns risk. Aside from being a poor approximation of how real-world spending actually works, it also tends to push households into spending patterns that are more conservative than needed. Households reduce spending during the prime years they could most enjoy it.

A better way to address sequence-of-returns risk is through the dedicated spending sleeve that I’ve described in other Field Notes. Rather than degrading a household’s spending across the board, the dedicated spending sleeve sets aside a small percentage of assets to fund spending during a down cycle. The household is rarely, if ever, forced to sell growth assets when the market is down, and this is accomplished through a surgical plan rather than degrading spending for the entire household for the entire duration of their retirement.

Footnotes

1. IRS, SOI Tax Stats – Historical data tables, “Table 23. U.S. Individual Income Tax: Personal Exemptions and Lowest and Highest Bracket Tax Rates, and Tax Base for Regular Tax, Tax Years 1913–2018″.