What’s Wrong With the 4% Rule?
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Bill Bengen’s 4% safe withdrawal rule is the standard by which retirement strategies are measured. But it fails as a practical guide to retirement planning. Here is how to fix it.
What is wrong with the old 4% withdrawal rule?
Bill Bengen’s famous 4% withdrawal rule has been a longstanding strategy since the 1990s. It works by withdrawing an amount equal to 4% of your retirement savings the first year of your retirement. Subsequently, the payments are adjusted each year for inflation.
This rule advocates constant spending in real dollars every year, no matter how the underlying portfolio performs. The investment strategy is disconnected from spending needs and the income-generation objective.
It is problematic and a significant shortcoming when the investment strategy and the payment mechanism are detached and do not work well together. The payout strategy should be integrated with an investment strategy specifically designed to support it.
Moreover, because the initial retirement income depends on (4% of) the market value of your savings at the time of retirement, sudden market swings close to the retirement date will create anxiety and have a big impact on the beginning (and likely subsequent) income.
This may all lead to a sub-optimal standard of living in retirement, with retirees either ending their lives with a significant balance remaining in the investment account or running out of money too early and ending with no income.
The new 4% approach
The new 4% approach to investing and spending in retirement is a special case of a percentage-based approach, which is derived from the so-called iTDFs (individualized target date funds) framework. It deals with the complex decisions of how to invest and how to draw down retirement savings over an x-year period post-retirement.
Retirement incomes are determined based on a smoothed benefit basis. The beginning income is determined to be 1/x of this basis. If x=25 years, the beginning income is equal to 4% of the smoothed benefit basis. If x=30 or 20 years, the beginning income is equal to 3.33% or 5%, respectively, of this basis.
The subsequent retirement incomes are automatically adjusted in line with the performance of this basis, i.e., in response to smoothed investment returns. They are smoothed up or down, depending on whether the smoothed returns are positive or negative. Overall, the income in retirement is expected to increase over time as the accumulated smoothed investment returns are expected to be positive.
The built-in drawdown and investment strategies adapt automatically and dynamically to each other over time. They are integrated and coordinated by surprisingly simple mathematical formulas and constitute a unified whole in an innovative way. The investment strategy supports the income-generation objective to smooth retirement income.
The full market-linked return is passed on to the individual investor during both the accumulation and decumulation periods. Although the investment account value may fluctuate significantly in the short term, the formulas dynamically determine an income that would not fluctuate with market conditions.
The formulas also mitigate the risk that sudden market swings close to the retirement date might have on the beginning income. Efficient use of capital is made without the need for individual or collective capital buffers.
How does it work?
The new 4% approach balances the trade-offs between overspending and running out of money in retirement and underspending holding back money due to the worries over ending with no income. The investment account is exhausted at the end of the 25-year period with mathematical certainty.
It works during the savings and withdrawal phases, pre- and post-retirement, respectively. The accumulation and decumulation phases are combined seamlessly. In this way it avoids having separate products for pre- and post-retirement which might create an artificial cliff edge at retirement and there is no need to disinvest and then reinvest.
The new 4% approach provide personalized dynamic investment strategies and smoothing of retirement incomes for everyone. The desired or default degree of smoothing and investment horizon pre- and post-retirement determines the investment-risk profile (e.g., high, medium, low) during accumulation and decumulation. Investment-risk exposure is reduced as investors get older – avoiding excessive investment risk-taking at old age.
Contrary to the old 4% rule, the new 4% approach gives each investor a personalized dynamically self-adjusting glide path where asset allocations are automatically adjusted between a risky (diversified) investment fund and a less volatile (diversified) investment fund.
Asset allocations adapt automatically in response to investment market developments and the capacity to take on or limit investment risk (i.e., actuarial funding status of the current level of retirement income). In this way, the balance between assets and future liabilities is adapted and payments can be smoothed while remaining responsive to financial markets’ performance. This is important to sustainable payment of smoothed retirement income.
The new 4% approach (and in general the x% approach) is a managed-payout solution making decumulation and accumulation easy for investors. It may also work well as a building block in combination with other retirement products.
Per U.K. Linnemann, Ph.D, M.Sc. has spent a lifetime working on pensions in industry, academia and government. Per is now principal and founder of Linnemann Actuarial Consulting. He dedicates his work to creating the next generation of retirement income solutions filling the need for normative investment strategies and product innovation in the payout phase.