The average American will live to see their 78th birthday and 30% of us will live to see 90! When planning for retirement we have to assume we will be living off savings for 25-30 years! This can be an overwhelming idea. How can we save enough to live for 30 years with no work-related income? How can we be certain that we won’t out spend our savings?
The 4% rule
In 1994 William Bengen, a financial advisor in California, performed an exhaustive study of various retirement savings withdrawal strategies. Examining stocks and bonds over the period of 75 years, he discovered something shockingly simple. He determined that if a retiree withdrew no more than 4.1% of retirement funds in the first year and then, in subsequent years added inflation to the previous year’s withdrawal, there was no period of time that a retire would risk exhausting their savings. This was true even for folks that retired October 28, 1929, the day before the great depression. Thus was born the 4% rule. It was published in the October 1994 issue of the Journal of Financial Planning. Criticism of the 4% rule was swift and harsh. Nevertheless, two university studies (The “Trinity Studies”), one published in 1998 and the other 2010 offer rigorous peer-reviewed support to Bengen’s 4% rule.
Planning retirement using the 4% rule
The beauty of this “rule of thumb” becomes obvious when we actually plan for retirement. Let’s say for a moment that you have decided that you could retire comfortably on $100,000 a year. Assuming that social security will pay $34,000 then we know that you will need to withdraw $66,000 a year from savings. If we use Bengen’s rule, then it’s simple to calculate that you will need to have ~$1.6 million saved for retirement. ($66,000 / 0.041).
So why so much hate for the 4% rule?
One cannot help but wonder if some of the shade cast on the 4% rule is because it is so simple. You certainly don’t need to be a certified financial planner to use it. In fact, one criticism that’s widely repeated by financial planners is that the 4% rule was only tested using a specific 60%-40% mix of stocks and bonds. If this were true, this would problematic. Interest rates are currently at historic lows meaning that retirees either have to accept lower overall portfolio returns or hold a greater proportion of their nest egg in higher performing higher risk stocks. While Bengen may not have rigorously tested various combinations of stocks and bonds, the Trinity studies did. And the rule held. So this often quoted limitation is simply untrue.
Real limitation of the 4% rule
Probably the biggest failing of the 4% rule is that it’s too conservative. The worst case scenario for a retiree is to retire at the start of a recession. Devaluation of accounts combined with low returns at the start of one’s retirement means that accounts are rapidly depleted and never have the opportunity to recover. The 4% rule assumes that you will retire the day before the next great depression and if you do, you will never run out of money. In fact, one well known planner, Michael Kitces, looked individuals who retired right at start of the 2008 global financial crisis and found that as long as they stuck to the 4% plan, they were doing just fine. Even with today’s low interest rates the 4% rule seems to be working.
Fortunately, most of us won’t retire the day before the economy careens over a cliff. If we stick to the 4% rule it’s likely that we will have lived too conservatively essentially leaving our heirs a bigger than expected inheritance. What’s the problem with this? You would have deprived yourself of well-deserved luxuries. Luxuries that you heirs will enjoy.
Monte Carlo simulation and the 4% rule
Despite having some flaws, the 4% rule still a pretty good starting point when planning for retirement. The trick is to use it as a rule of thumb, not a rule of law. Then compare the 4% to other retirement forecasting methods such as the Monte Carlo simulation. The Monte Carlo simulation uses all the possible outcomes for key economic factors such as interest rates and market returns. Using these, it then generates 1000s of possible scenarios and their proabilities. The Monte Carlo simulation can tell us the “likely” as well as the “range” of possible outcomes for our retirement accounts.
Monte Carlo simulation
Monte Carlo simulation also has its limitations. For one, key pieces of information such as the probability distributions for interest rates and market returns are based on historical averages. Not all simulation software use data derived from the same historical time period. Also, changes in the current environment can affect the future in ways not predicted by a historical model.
Nevertheless, when used together, the 4% rule and Monte Carlo simulation can be very powerful in retirement planning. The Flexible Retirement Planner, an easy to use, well respected Monte Carlo simulation program can be downloaded for free here. Interestingly, in our example above the program gives us a 99.9% chance of successful retirement if we withdraw $62,000 our first year of retirement; however, we can withdraw up to $124,000 and still have a greater than 85% chance of success. It’s a very powerful piece of software but I would urge you to read the manual!
The idea of needing enough savings to last 25-30 years can be overwhelming. Using the above tools younger veterinarians can estimate how much they will need to save while those closer to retirement can estimate how much they can spend in their “golden years”!