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The 4% rule and other fallacies of retirement planning — Pop Economics

The 4% rule and other fallacies of retirement planning

by Pop on February 24, 2010

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There’s a reason it’s called a retirement plan.

When you go to a financial planner or try out a quickie retirement calculator, it’ll often come back with a result that reads something like “Sticking to this allocation and savings plan, you’ll have a 90% chance of meeting your retirement needs.” A good financial planner will translate that for you, but a retirement calculator will just leave you hanging.

Is a 90% chance of meeting the target high? Is it low? Is a 10% chance of not meeting your target particularly high or low? Who knows?

The invention of the 4% rule

The “4% rule” is a common rule-of-thumb used to guide retirees when they’re getting ready to tap their nest egg. Let’s say you retired with $1 million. The rule says that in the first year, you can withdraw $40,000 (4% of $1 million). In year two, you can withdraw $40,000 plus a slight adjustment up for inflation. And so on.

You might not be as familiar with how that rule started. In 1998, a trio of professors at Trinity University penned a study looking at historical returns, withdrawal rates, and life expectancies. A table in the study broke down probabilities of success based on a 2% withdrawal rate, 3%, 4%, 5%, and so on. Four percent was simply the highest withdrawal rate where, most of the time, the probability to success was near 100%. So, all the media folks and financial planners turned it into mantra.

But was that what the professors intended? Not at all. In fact the study concludes: “For stock-dominated portfolios, withdrawal rates of 3% and 4% represent exceedingly conservative behavior.” Why did everybody gravitate to 4%? They were mesmerized by that 100% success rate.

How retirement really works

I wrote something recently for Consumerism Commentary that basically argued a 7% chance of not meeting your target is pretty high. I mean, it doesn’t seem high until you’re part of the 7%. Then you’ll wish you had invested as if you had a 99% or 100% success rate.

I still agree with what I wrote a little while ago, but I think I’m guilty of committing a wonkish mistake. You see, if you deal with these kinds of calculators and statistics and historical returns and probabilities long enough, you start to forget how people actually act. It’s like getting so caught up in batting averages and ERAs that you forget what a game looks like when it’s played.

I can set up a retirement plan for myself that the calculator says will give me a 100% chance of meeting my retirement income goal, but in the end, that ends up being a pretty useless exercise. Retirement calculators necessarily make you plan out 40 or 50 years of your life, but they don’t take into account humans’ abilities to adapt.

If someone saw their account balance drop dramatically in 2008, they probably ratcheted back their spending. On the other hand, if someone hits age 85 and still has millions in the bank, they probably decide to splurge a bit. We don’t set a plan at age 65 and blindly follow it as if nothing has changed for 30 years. That’s just stupid. (And that’s what a retirement calculator assumes.)

Your plan is more flexible than you think.

Where does that leave you and your retirement calculator? You could set up a plan that’s effective 100% of the time. Your calculator will tell you that you have to save a ton of money or work well beyond age 65. But in exchange, you’ll sacrifice a lot — maybe too much — of today’s standard of living to get those extra percentage points of certainty.

So next time I use a retirement calculator, I might not panic if it says I only have an 85% chance of meeting my retirement goal. Even when I enter retirement, I might try a 5% withdrawal rate, which according to the Trinity study, would give me an 80% chance of not outliving my money. As time goes on, I’ll adjust up or down depending on what life and the market throws at me.

After all, in 2020, I know I won’t look at the plan I wrote in 2010 and keep following it blindly. So why should I plan as if I will?


{ 7 comments… read them below or add one }

2 Cents February 24, 2010 at 8:46 am

Retirement planning asks you to estimate a lot of unknowns and variables and to predict the future. How can we possibly know at 20 or even 40 how much money we will be able to earn or save over our lifetime? How can we accurately predict the return on our investments or the effects of inflation? No wonder governments and corporations are shifting the responsibility of retirement planning to us – it’s really hard!

Difficulties aside, we all need a plan. I like the idea of building flexibility into it and revisiting the numbers often.

Rob Bennett February 24, 2010 at 3:55 pm

The Old School Safe Withdrawal Rate (SWR) studies don’t account for the valuation level that applies on the day the retirement begins, Pop. Thus, these studies get all the numbers wildly wrong. We are likely going to see millions of people who suffer failed retirements in days to come as a result of the demonstrably false claims put forward in these studies.

I have an analytically valid New School SWR calculator (“The Retirement Risk Evaluator”) at my site. This calculator does include an adjustment for valuations. It shows that the SWR can drop to as low as 2 percent when valuations are where they were from 1996 through 2008 and can rise to as high as 9 percent when valuations are where they were in the early 1980s and are likely to be again sometime within the next few years.

The fact that these studies have not been corrected for eight years after we discovered the errors in them at the Retire Early board at Motley Fool is a scandal. It reflects poorly on the entire investing advice industry. Dallas Morning News Columnist Scott Burns acknowledged that the only reason why the media has not publicized the errors made in these studies is that the accurate numbers constitute “information most people don’t want to hear” during an insane bull market.


Ken February 26, 2010 at 6:17 am

I think that needs at retirement can vary greatly from one person to the next. People can make adjustments and live on much less if that’s what they truly want. I do think it’s important for folks to ask themselves the right questions as they progress toward retirement. One good question is: What kind of lifestlye do I want to live in retirement? Good post.

K Smith February 26, 2010 at 1:08 pm

I think relying on retirement calculators the wrong way to go.

These calculators are based on historic market activity generated by conditions that no longer exist. Because of the massive amount of government debt, mountains of looming local, state, and federal pension payouts, and promised federal entitlements that we cannot afford to pay, relying on historic market activity is a bad basis for decisions on cashing out your portfolio.

The critical question today at retirement is not how much should I cash out each year – it is what form should my portfolio take. Investing today is like walking into a casino, with worse odds of coming out ahead. At least in a casino you can play blackjack – with simple card counting the odds are you will beat the house. In today’s investing world, the rules of all the old dollar denominated games have changed, and the odds heavily favor the house. The games that appear to have the best odds of beating the house require Chinese yuan, or Australian or Canadian dollars.

If the value of your portfolio continues to shrink, spending time attempting to preserve what you have left is a far better use of your time than thinking about how much to cash out.

Michael April 15, 2010 at 7:15 pm

The thing that gets me about retirement planners is that the vast majority of your income generated is in the last few years before retirement, which can be 20 or 30 years away. How do we know if the four year period between 2035 and 2039 the market is going to return 8% per year? We have no idea.

Tim April 28, 2011 at 11:12 am

We don’t set a plan at age 65 and blindly follow it as if nothing has changed for 30 years. That’s just stupid. (And that’s what a retirement calculator assumes.)

A good planner knows you update the plan every 6-12 months so it is every changing. You would never be in 2020 using a 2010 plan, you would be in 2020 using a 2020 plan. Your not trying to predict the future, your trying to plan for worst case scenario to know if you should retire in the first place.

jim April 28, 2011 at 12:19 pm

Hell, I’m retiring this year and I don’t know how much I should, or will take out. 3%, 4%, 6% who knows. Should I take it all out at once and put it in a coffe can or should I take it out in bits each month, and let the rest stay put and hopefully gain some interest. Ask a planner and all I get is a look like a deer in head lights. I guess the best answer is just jump in with both feet and see what happens, hold onto my wallet and take away my wifes credit cards.

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