We are now living in a dynamic world that is evolving rapidly. To keep up with the advancements, we must ensure that we do not simply rely on old models and be in a false sense of security. This article will explain how we could modify the 4% rule to make it suited for retirement in today’s world.
The original 4% rule
The 4% rule is a very popular rule of thumb that is used to determine how much of the total investment portfolio a retiree should withdraw each year so that he can survive his entire retirement without getting out of money.
Essentially, it says that a retiree could withdraw “4%” of his investment portfolio for a period of 30 years without running out of money. The rule also accounted for inflation – the retiree could withdraw an extra 2% of the last withdrawn amount. This rule became widely popular when it was first introduced by Bengen in 1994.
But, things are not the same as they were during that time. The interest rates and the market outlook has changed drastically since then. Also, retirees are now seeking a retirement term that is a lot more than 30 years.
The 4% rule has certain limitations
As I said earlier, the “4%” rule is a thumb rule, meaning that it gives us a “rough” estimation about the amount a retiree could withdraw each year.
The rate of “4%” was calculated by using simplifying assumptions. Some of the assumptions taken during the calculation don’t hold in today’s world, and the other assumptions were not practical in the real world.
Let’s discuss what those assumptions are and what their limitations are.
Assumption #1: Reliance on past returns
The rate of 4% was calculated assuming that the market would continue to perform as it performed in the past. However, the market conditions and the interest rate scenario have drastically changed since.
During 1926-2021, the average historical returns were as follows:
- US Stocks: 10.37%
- US Bonds: 5.30%
- Inflation: 2.87%
But, we obviously know that the future will not be the same. According to a forecast by Vanguard, the 10-year future returns would look something like this:
- US Stocks: 4.02%
- US Bonds: 1.31%
- Inflation: 1.58%
Certainly, this is a huge difference. We now know that the simplifying assumption “past performance is an indicator of future results” is not an ideal one and thus, makes the 4% rule obsolete.
Assumption #2: No investment fees
Bengen assumed that investors’ returns are the same as those on market indexes. However, this is far from reality. The fees on any type of investment vary between 20 bps (basis points) to 100 bps. The higher the fees, the lower the 4% rule’s probability of success.
A Vanguard study found that for a 4% withdrawal rate, having 20 bps investment fees gives investors a 28.8% probability of success; with fees of 100 bps, that probability plunges to just 8.6%. An important lesson – costs matter, and taking them into account is important.
Assumption (Limitation) #3: Retirement period of 30 years
Bengen calculated the 4% rate assuming a retirement period of 30 years. While a retirement period of 30 years was okay considering the time this thumb rule was made, people today want a longer retirement period that can extend as long as 50 years.
Another reason that we now have a longer retirement period is because the F.I.R.E. (Financial Independence Retire Early) movement is increasingly becoming popular, and the life expectancy of an average person has increased considerably.
According to simulations by Vanguard, with a 4% withdrawal rate, going from a 30-year to a 50-year retirement horizon decreases the probability of success from 81.9% to 36.0%.
Assumption (Limitation) #4: No diversification
While calculating the 4% rate, Bengen considered only US Stocks and Bonds allocation. It might be a good strategy back then, but today, there are several asset classes, and it is a good idea to diversify the portfolio to manage risk.
Global diversification is a powerful strategy to manage portfolio risk. A Vanguard research demonstrated that global diversification could boost the 4% rule’s probability of success.
Assumption (Limitation) #5: Fixed percentage withdrawal
The 4% rule was designed to allow retirees to maintain a constant standard of living (adjusted for inflation), no matter if the market performed good or bad.
But this assumption is not realistic. In the period of boom, people tend to spend more, and in volatile times, people spend less.
The rule is also not feasible when the market falls drastically. For example, if the market falls substantially in a given period (like the 2008 financial crisis), the 4% rule would advise boosting spending each year to account for inflation. This can substantially increase the risk of portfolio depletion in retirement.
On the other hand, if the market goes up substantially, this rule would still limit the retiree from maintaining his regular standard of living.
Modifying the 4% rule to make it more realistic…
Now, when we know certain assumptions and limitations of the 4% rule, let’s see how we could modify it to accommodate it in the present, real-world scenario.
The researchers at Vanguard have designed a “Dynamic Spending Rule” that allows investors to spend more when markets are performing well and reduce spending amounts when markets are performing poorly. The rule also overcomes the limitations of the traditional 4% rule.
The Dynamic Spending Rule (Modified 4% rule)
The Dynamic Spending rule establishes ceilings and floors on annual spending. It introduces a ceiling of 5% and a floor of 1.5%. Let’s understand the dynamic spending rule through an example.
The below table contains two cases. The initial wealth is $1 million in both cases, and the first-year market return is 0%.
In the second year, the first case return is 10%, and the second case return is -10%. For simplicity, we assume inflation is 0% in both years.
Regardless of market performance, the 4% rule allows investors with an initial $1 million portfolio to withdraw $40,000 annually, assuming no inflation. On the other hand, in good market scenarios, the dynamic spending rule can allow investors to withdraw more money than the 4% rule does. And when the market goes down substantially, the dynamic spending rule cuts back spending so that investors benefit more when the market rebounds.
This simple modification in the 4% rule significantly improves the probability of success. According to simulations by Vanguard, by adopting the dynamic spending rule, investors can increase their probability of success to 90.3%, from 56.3% under the 4% rule.
Not only does it increase the probability of success, but it also solves all the limitations that were present in the original 4% rule. Also, the assumptions in the dynamic spending rule are more realistic, and thus, we know that the simulation results will be more accurate in the actual world.
The Dynamic Spending rule solves for all the limitations in the 4% rule and incorporates realistic assumptions. If you are someone who is looking for retirement soon or a F.I.R.E. follower, the dynamic spending rule will prove to be a useful tool for planning your retirement.
The 4% rule was a good thumb rule to determine the amount that a retiree could withdraw each year, but it is not suited for the present-day real-world scenario. Researchers at Vanguard have developed the modified 4% rule, which they call the “Dynamic Spending Rule.”