The 4-per-cent rule doesn’t take into consideration factors like sequence risk, which can have a significant impact on the overall value of a portfolio long term.Ridofranz/iStockPhoto / Getty Images
For almost three decades, many investors and financial professionals have looked to the “4-per-cent rule” as a rough guide for how much money they would need to withdraw from their portfolios annually to retire comfortably.
The rule, developed by financial advisor William Bengen in 1994, states that retirees with a 30-year time horizon could withdraw 4 per cent of their portfolios in the first year of their retirement, followed by inflation-adjusted withdrawals in subsequent years.
It’s the foundation for popular investment strategies like the “Financial Independence Retire Early” movement and a regular topic of discussion between everyday investors and their advisors.
What started out as research – based on historical returns for stocks and bonds from 1926 to 1976 – has become one of the most talked about, scrutinized, and misunderstood investing rules of thumb around, even as many experts argue it’s increasingly irrelevant amid volatile markets, a wider variety of retirement income sources and longer lifespans.
The main problem with the 4-per-cent rule is that it’s a one-size-fits-all approach, said Moshe Milevsky, a finance professor in the Schulich School of Business at York University in Toronto, during a webinar presentation for members of the Financial Planning Association of Canada.
“There’s something odd about a rule that’s one-dimensional,” Mr. Milevsky said. “Four per cent regardless of tomorrow? I think decumulation plans must be multidimensional. A good decumulation plan tells me what to do not just based on inflation – adjust up, adjust down – a good decumulation plan tells me what to do in many states of nature, like a matrix. If the markets are up, this is how much you adjust; if the markets are down … telling someone to withdraw the exact same amount of money in inflation-adjusted terms, no matter what, doesn’t make a lot of sense.”
For instance, Mr. Milevsky said the rule doesn’t take into consideration factors like sequence risk, which is the threat of receiving low or negative returns early in a period when withdrawals are being made. That can have a significant impact on the overall value of a portfolio long term.
What’s more, Mr. Milevsky pointed out that there are many incarnations of the 4-per-cent rule today and even the creator, Mr. Bengen, has challenged his own research over the years.
Still, the catchy 4-per-cent measure appears to have stuck.
Rona Birenbaum, certified financial planner and founder of Toronto-based fee-only financial planning firm Caring for Clients, believes the 4-per-cent rule is still cited, in part, because it simplifies the complex puzzle of individualized retirement planning.
“It was never intended to be gospel,” Ms. Birenbaum said in an interview.
For her, the 4-per-cent rule is useful for people who are starting to think about retirement planning, “but it’s not intended to be used as a decision-making tool,” she said. “It’s like a temperature check, but there are many Canadians for whom it’s of no use at all.”
For example, Ms. Birenbaum says the rule is of less use for people who have a defined-benefit pension plan that covers a large percentage of their income needs, which is indexed to inflation and provides guaranteed income in retirement. It means retirees could draw on their savings more aggressively in their early years, knowing they have that pension income cushion.
The rule also doesn’t take into consideration other assets people have such as a home or recreational property that could be sold if someone chooses to downsize in their later years.
“If you have those other assets, you might be quite comfortable, and it could be prudent to draw more aggressively on your savings in the early years of retirement and replenish those savings from the sale of real estate down the road,” Ms. Birenbaum said.
It also doesn’t consider whether retirees want to leave money to beneficiaries, such as children or charities.
“The more money you want going to those beneficiaries, the less money you should spend in your retirement,” she said.
And while purchasing a life insurance policy can ensure there’s an estate value at the end of the day, Ms. Birenbaum notes that premiums may require investors to withdraw more money in retirement than the 4-per-cent rule would support.
“So, if using the 4-per-cent rule exclusively, you could be overspending and not know it and compromising the longevity of your capital, or you could be underspending [or undergiving] and dying with too much money,” she said.
The rule also doesn’t account for lump-sum withdrawals that might be needed in retirement for big-ticket costs such as a roof repair, a new car or recreational vehicle, or helping a child buy a home, said Janine Guenther, president of Dixon Mitchell Investment Counsel in Vancouver, in an interview.
“People take money out of their retirement savings, in a very lumpy manner.”
Retirees also tend to be more active in their early years, with travel, hobbies, or other pursuits, which might mean more spending in their 60s compared to their 70s and 80s. Or, some may need to spend more in their 80s and 90s on health care or assisted living.
“It’s really important as an advisor to be able to accommodate for different spending cycles so that you can give your clients a realistic exposure to what can happen,” she said.
Mr. Milevsky encouraged advisors and investors during his presentation to look past the 4-per-cent rule if they want successful retirement planning.
“I’m not saying that withdrawal rates aren’t important, but you have to focus on many other things,” he said. “The way I would look at it is: What is the minimum amount of information you need to know about someone who is planning to decumulate? And how exactly do you map that into a long-term drawdown strategy? What are the things you have to ask someone before you tell them how much they can withdraw? It can’t just be the value of the portfolio of times X. It just can’t be.”