Monday, April 4, 2016

Revisiting the 4 Percent Rule

Many people have opinions about William Bengen’s 4% rule for annual retirement spending. William Bernstein said that 2% is “secure as possible,” 3% is “probably safe,” 4% is “taking real risks,” and at 5% “you had better like cat food.” However, Frederick Vettese says 5% is “relatively safe” and that 6% or 7% “might not be outlandish.” Here I examine Vettese’s reasoning for these conclusions in the chapter “Revisiting the 4 Percent Rule” of his book The Essential Retirement Guide.

Bengen’s original 4% rule is based on a fictitious retiree with no spending flexibility at all. Upon retiring, the retiree chooses a yearly spending dollar amount and increases it by the cost of living each year without regard to how his or her portfolio performs. Bengen tried to figure out what percentage of your starting nest egg would give a safe spending level. Using historical U.S. stock and bond returns, he came up with 4%.  This inflexible approach is how he calculated his safe initial spending percentage, but he was clear that a real retiree may choose to increase or decrease spending in the face of a portfolio that is declining severely or growing wildly.

So, if you start with a million dollars when you retire, spending $40,000 per year rising with inflation is probably safe for about 30 years. Keep in mind that in the second and all subsequent years, you aren’t necessarily spending 4% of your portfolio each year. If your portfolio performs well, you may be spending less than 4% of what you have left, but more likely you will be spending more than 4%.

Vettese chose to interpret “4% rule” differently. He assumes that you would spend 4% of whatever is left of your portfolio each year. This implies that you are quite flexible in how much you spend. It also implies that you could never run out of money because you never spend all of it. I’ll distinguish these two approaches calling Bengen’s the “initial 4% rule” and Vettese’s the “4% each year rule.”

A major problem with the 4% each year rule is that it takes no account of your age. As your remaining life expectancy diminishes, it makes sense to be able to spend increasing percentages of your savings. With one retirement spending strategy I worked out, the percentage of your portfolio you spend is 4.17% at age 60, 4.43% at age 65, 6.17% at age 80, and continues to rise. The actual dollar amounts don’t necessarily rise, though. Your portfolio is unlikely to keep up with these ever-rising percentages, so each year you’ve spending a higher percentage of a shrinking inflation-adjusted portfolio balance. The percentages are chosen so that if your portfolio performs as expected, the yearly inflation-adjusted spending amounts remain constant.

Vettese goes on to run Monte Carlo simulations of a 5% each year rule from age 65 to 80. He assumes you’d buy an annuity at age 80. Based on these simulations he concludes that this approach is “on the right track.” The implication is that we can compare this 5% each year rule to Bengen’s initial 4% rule. But this is an apples to oranges comparison. With Bengen’s rule, unless your portfolio outperforms, you’re withdrawing more than 4% each year because his 4% refers to the starting portfolio size. In fact, Vettese may have you spending less than Bengen after the first few years.

Comparing Vettese’s 5% each year rule to my retirement strategy discussed above, I actually have you spending an average of 5.07% during the years from age 65 to 80. So, Vettese hasn’t given you an extra 1% to spend. What he’s done is boost the amount you spend in your 60s at the expense of what you can spend thereafter.

An unfortunate artifact of the 5% each year rule to age 80 is what happens after buying the annuity. An 80-year old male can buy an annuity that pays out over 9% per year. Even if the payments are indexed by 2% each year to partially offset inflation, the starting payout is still over 7%. But with Vettese’s plan, you only get to spend 5% at age 79. His simulations have you scrimping in your late 70s so you can live larger after turning 80.

Overall, just comparing the percentages (4% and 5%) in the two rules is highly misleading. The only time it makes sense is in the first year of retirement when Vettese has you spending more than Bengen does. After that, the comparison is more complex.


  1. Good Morning Michael;

    AHH! The good old 4% withdrawal rate.
    IMHO this statement should be qulaified as applying to non-registered and/or TFSA accounts only. For our RRSP's (read RRIF)the CRA tells us what to withdraw with 4% being applicable only when you are 65 years of wisdom. Above that you get to withdraw more, at least percentage wise, than 4%

    I don't debate whether or not 4%, or more or less, is a sustainable withdrawal rate, just that in the case of mandatory RRIF withdrawals we do not get to decide our rate of withdrawal. If you have a sizablke RRSP to convert to a RRIF then withdrawing less than 4% from non-registered and TFSA accounts may make a lot of sense. Diffeent strokes for different folks (and different finacial means)


    1. @Ricardo: I hear this a lot. There is no reason you have to spend everything that comes out of your RRIF. For example, you could put some of it in your TFSA or non-registered account. The mandatory RRIF withdrawals force you to pay some taxes, but they don't force you to spend more. That said, I understand that most people will just spend this money, but thoughtful people don't have to.

    2. Hi Michael;
      Agreed that we do not have to "spend it all". Never the less the CRA mandates the withdrawal percentage from our Canadian RRIF's.
      Again depending on the amounts you may have in your non-registered account(s) and TFSA, this manadatory withdrwal can/will affect how much may be needed from those accounts as well to supplement the RRIF withdrawal if lifestyle or simple monetary requirements (health issues/home repairs/travels/Corvette, etc) dictate extra funds.
      So someone with a $50K RRIF (which may just be the majority of Canadians from what I hear)would more than most likely need more than 4% from their non-registered funds just for necessities whle someone with a $2million RRIF might regret having socked so much away for tax reasons.

      Hopefully I will be one of those who can fully maximise my TFSA from my other non-registered account as well as maybe a RRIF surplus for several years before the principal dollar value starts to diminish. Naturally after I get my Corvette -LOL


  2. "The percentages are chosen so that if your portfolio performs as expected..."

    What are the expected portfolio returns used in the calculations?

    1. @SST: I use 4% real for stocks before MER and other costs. For fixed income, I use 0% real. If returns deviate (as they assuredly will), spending level adjusts.

    2. What is the portfolio mix?

      An interesting read from retirement specialist Wade Pfau:

      His 40-year "safe" withdrawal rates with a standard 60/40 portfolio are from 1-2.75% (depending on probable failure).

    3. @SST: The mix is 5 years' worth of spending in fixed income and the rest in stocks. However, there is no possibility of running out of money because spending adapts to portfolio size. So, you have to define failure differently from the strategies that keep spending the same amount blindly.

    4. @SST: I read Pfau's article. He doesn't say how he did the Monte Carlo simulations, but if he did them the way most people do by treating the years as independent from each other, then his results are too pessimistic. Stock prices over long periods of time show more mean reversion than you get with independent results. Roughly speaking, this means that stocks tend to bounce back after a long bad period and tend to drop after a long good period. However, simulations will over-represent the probability of poor stock performance lasting multiple decades. It's possible for us to drop into a 20 or 30-year recession, but it's not as likely as the simulations would indicate.

      All that said, the safe withdrawal rates are generally lower than 4% for retirees who never adjust their spending levels (except for inflation adjustments).

      I've written articles about this sort of thing many times. Just search for Bengen on my blog to see them.

  3. I will. Thanks for your work.

  4. If we only knew when we would die so we could all know how much we can spend until then. Ah, the "end game".

    Kidding aside, good post, and I didn't think Vettese's rule was very good in the book personally. There are too many assumptions and I'm much more conservative than that. Under the Bengen rule I think the majority of investors are rather "safe" as a rule of thumb with 4%.

    I don't really worry about those rules very much. I prefer to focus on a decent savings rate and killing debt. That's enough worry for me :)


    PS - previous comment deleted, didn't comment with my URL.

    1. @Mark: Actually, I don't agree that Bengen's 4% rule is safe for most people. The problem is that most people pay high fees. A 2% MER reduces the 4% rule to a 3% rule.

      There is little point in worrying too much about withdrawal rates until you get close to retirement. But then it will become very important.