By John H. Robinson, Financial Planner (February 2025)
In 1994, a California financial planner named William Bengen published a seminal paper in the Journal of Financial Planning titled, “Determining Withdrawal Rates Using Historical Data” His objective was to determine the maximum inflation-adjusted withdrawal rate a retiree could safely spend from a portfolio and not run out of money over a 35+ year retirement horizon in any investment environment. Bengen used a two-asset model consisting of the S&P 500 Index and 10-year treasuries. He applied historical back-testing as his simulation methodology.
Bengen’s Thought Leadership – Sequence of Returns Risk and the 4% Rule
The paper produced two major findings that changed the way investors plan for retirement spending. First, it raised awareness of sequence of returns risk. Bengen’s back-testing neatly illustrated how the portfolio of a 65 year-old retiree who has the misfortune of retiring just before a series of down years would likely run out of money far sooner than someone who began spending down a retirement portfolio before a series of normal or above-average return years. Prior to Bengen’s work, the prevailing primitive wisdom in the financial planning community was that withdrawal rates in line with historical average return from the stock market (8-12/% per year) should be sustainable.
Bengen’s second important finding was that the impact of sequence risk is potentially so significant that the maximum inflation-adjusted withdrawal rate that could survive even the worst 35-year periods in the modern historical record was around 4%. This was much lower than most financial advisors at the time would have guessed. Hence, the 4% safe withdrawal rate or “SafeMax,” as Bengen coined it, was born.
The Big Problem With the 4% Rule – Laughing Heirs
The timing of Bengen’s paper could not have been better, as it was published just as the first wave of Baby Boomer’s were approaching retirement. The nascent, but rapidly growing, financial planning community quickly embraced the concept of sequence risk, and the 4% rule became the tool that advisors (and DIY investors) applied to address that risk.
However, as a real-world solution, the 4% rule is an awful financial planning strategy. Specifically, by planning withdrawals around a worst-case-scenario, retirees will likely die with very happy heirs if future investment returns are historically normal or even well below normal. Expressed differently, retirees who follow an austere 4% withdrawal strategy will most likely under-spend their nest eggs and under-enjoy their retirement years.
A Better Way To Spend
A third important and often overlooked contribution of Bengen’s original research was that it spawned thousands of other research papers that advanced retirement income sustainability far beyond his original model. Bengen himself would go on to expand upon his original model in a series of papers published over the next decade or so.
Some of these diaspora papers expanded the number of asset classes while others enhanced the safe withdrawal rate by applying different spending rules or guardrails of varying complexity. Thirty-plus years later, the research-backed wisdom suggests that consumers should start with significantly higher initial spending rates and manage their spending and investment allocations dynamically over time to optimize/maximize their total lifetime spending. Under such modeling scenarios, consumers might realize inflation-adjusted spending rates of 7% or more in accommodating investment environments and even rates above 5% in scenarios where sequence risk rears its ugly head. See the following illustrative examples:
More Realistic Retirement Income Projections Require Dynamic Adjustments (CFA Journal)
Implementing Retirement Income Guardrails To Facilitate (The Right) Spending Raises And Spending Cuts (Kitces.com)
Retirees – Stop Under-spending in Your Go Go Years (Income Lab Podcast)
The Sources of Bad Retirement Spending Advice Today
Despite the significant advances that have been made in retirement income sustainability research, the guidance that trickles down to consumers continues to be predominantly badly dated.
In my opinion, the poster child for awful spending advice is Dave Ramsey, who apparently never got the memo that sequence risk is actually a real thing and continues to preach that consumers should be almost entirely invested in stocks in retirement and withdraw at an 8% rate. It matters not that he has no financial planning background or qualifications. As a charismatic speaker with a loud megaphone and a big flock, his misguided spending strategy has the potential to do real harm to consumers who act on his uninformed bombastic schtick.
The F.I.R.E. (financial independence, retire early) movement continues to grow, particularly among the Millenial and Gen Z crowd, and a common mantra among various online F.I.R.E. forums is the goal of accumulating a nestegg of 25X earnings as quickly as possible and retiring with a 4% withdrawal rate applied to that dollar amount. In addition, to the aforementioned discussion of how inefficient this spending model is, F.I.R.E. disciples should be aware that the 4% rule was intended to model a 30-year retirement horizon for someone retiring at age 65. It was never intended to be applied to an investor who retires at age 45. The YouTube and TikTok finfluencer crowd do much to perpetuate this myth too.
However, what bothers me most about the 4% Rule’s persistence in the retirement planning lexicon is that it continues to be promoted and perpetuated by research institutions that really should know better. For instance, Morningstar, a leading distributor of mutual fund and stock performance data for consumers and professionals, recently published a paper suggesting that the 4% rule may actually be too high and that they are advising newly minted retirees to consider applying 3.7% as the initial spending rate to their portfolios. Morningstar’s research was trumpeted in the following article in Barron’s:
New Retirees Should Plan to Spend Less Than 4% a Year. Why the Stock Market Rally Is to Blame. (Barron’s 12/11/2024)
The Morningstar article provided the inspiration for me to create this post. Morningstar is a respected mainstream research publication, but this guidance is nowhere near the leading edge of retirement spending research. Again, the very idea of applying a safe withdrawal rate is almost never sound planning advice. The 4% Rule (and all similar iterations) really needs to be retired.
John “J.R.” Robinson is the owner/founder of Financial Planning Hawaii and Fee-Only Planning Hawaii and is a co-founder of personal finance software maker Nest Egg Guru.
ADDENDUM
Comments I Posted to Barron’s
The Morningstar report is generating lots of press, and it is a huge disservice to investors. Simply put, the 4% Rule for retirement spending sustainability needs to be retired. The academic/professional research community long ago rejected this as a planning metric, and Morningstar should know better.
There are so many problems with the Morningstar article that it is difficult to know where to begin. First, basing one’s retirement savings on a safe withdrawal rate is a highly inefficient strategy that will likely cause retirees to underspend in retirement and lead to laughing heirs when they die.
Second, Monte Carlo simulations are not probabilities in the way that investors think of them as a “likelihood”. In fact the bottom 10% of simulations in most of these models are as bad or worse than any period in the modern historical record. In that light, it should be easy for investors to see that the bottom decile simulation result is not really a 10% probability of occurrence in the real world.
The percentages simply refer to the number of simulations that failed before the 30-year time period. The outcomes are entirely dependent upon the assumptions about expected mean returns and standard deviations for each asset class (both of which vary over time and are not predictable). It is easy to make a minor tweak to make the simulation results better or worse. This is why, if you run 10 different Monte Carlo simulation apps, you will get a wide range of results.
