Once upon a time, in southern California in 1994, there lived a man named William Bengen.⠀
His friends called him Bill.
Bill was born in Brooklyn, and he studied aeronautics at MIT. He wrote a big paper on advanced model rocketry. Then he became an executive at a soft drink company. Finally, 17 years later, he retired to sunny southern California.
Well, kinda.
Bill was smart and full of energy. He couldn’t stay retired for long. He decided to get a masters in financial planning. He opened his own firm.
And he started reading papers that … bemused him.
You see, at this time, many financial planners were claiming that since the stock market historically returns 7-9 percent compounding rates on average, retirees could withdraw and spend 7 percent of their portfolio. ⠀
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Bill had a hunch that this was misguided. He decided to prove it.
He looked at 30-year timespans in U.S. history, starting from 1926. The first timespan ranged from 1926 to 1955. The second timespan ranged from 1927 to 1956. And so forth.⠀
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He assumed that a retiree held 50 percent stocks, in the form of an S&P 500 Index, and 50 percent bonds, in the form of intermediate-term government bonds.⠀
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Then he asked two questions:⠀
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First, what was the worst-case scenario? Answer: retiring in 1966. The 16-year timespan from 1966 to 1982 was extra-rough. Enduring this at the start of retirement would make for one sad, sad puppy.
Second, how much could an investor sustainably withdraw from her portfolio during that worst-case scenario? The answer was 4.15 percent in the first year, and 4.15 percent, adjusted for inflation, every subsequent year.⠀
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And thus, the 4 percent rule-of-thumb was born.
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The 4 percent rule says a retiree can safely withdraw 4 percent of their portfolio in the first year of retirement, and 4 percent adjusted for inflation every year thereafter.
This has become a popular rule-of-thumb in the world of retirement planning. Here’s how it plays out:
- If you have a $1 million portfolio, you could withdraw $40,000 in Year One of retirement, and $40,000 adjusted for inflation every following year.
- If you have a $1.5 million portfolio, you could withdraw $60,000 in Year One.
- If you have a $2 million portfolio, you could withdraw $80,000 in Year One.
And so forth.
The corollary to the 4 percent rule is the “multiply by 25” rule. To figure out how much money you need to retire, multiply your yearly withdrawal rate by 25.
Let’s say you want to retire on $50,000 per year. Your rental properties collect $20,000 annually. If you want to generate the remaining $30,000 per year from your portfolio, you’d need an investment balance of $30,000 x 25 = $750,000.
Simple enough.
But it might be flawed.
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Recently, I interviewed Dr. Wade Pfau on my podcast. He holds a Ph.D. in economics from Princeton and works as a professor of retirement planning.
And he has a few concerns about the 4 percent withdrawal rule.
Here’s the problem, Dr. Pfau says: the 4 percent withdrawal rule is based on 20th-century data. It assumes the markets will perform as well in the future as they did in the past.
But what if future markets don’t perform as well?
Other retirement thinkers have voiced similar concerns, leading some to advocate for a 3 percent withdrawal rule. (Eek!) But this is a depressing idea. Switching from 4 percent to 3 percent adds years to your cubicle-dwelling life. This changes the equation from “multiply by 25” to “multiply by 33.”
- If you want to withdraw $40,000 per year, the equation becomes $40,000 x 33 = $1.32 million.
- If you want to withdraw $60,000 per year, the equation becomes $60,000 x 33 = $1.98 million.
- If you want to withdraw $80,000 per year, the equation becomes $80,000 x 33 = $2.64 million.
Um, No. Thanks.
Any other ideas?
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Fortunately, there are ways to salvage the 4 percent withdrawal rule. Here are a few palatable approaches.
#1: “Flexibility is the only true security.”
This quote from JL Collins — “as the winds change, so will my withdrawals” — says it all. When it comes to money management, all the spreadsheets and charts in the world can’t compare with good-ol’-fashioned flexibility.
Here’s how this applies:
The 4 percent withdrawal rule is built on the idea that you’ll increase your withdrawals at exactly the rate of the Consumer Price Index inflation.
But who does that??
Realistically, your spending habits won’t change at the rate of the CPI. Because you’re human. And that’s great, because it gives you options.
If you want to make the 4 percent withdrawal rule work, you could:
– Take out 4 percent without adjusting for inflation for a handful of years. For example, you could withdraw $60,000 per year (not adjusted for inflation) for the first 3-5 years, then make a one-time inflation adjustment, then hold steady for the next 3-5 years. This means you’re withdrawing slightly less money (in terms of purchasing power) every year, but you won’t “feel” the pinch as much. And doing this at the beginning of your retirement can make a massive compounding difference.
– Start a side hustle, such as freelancing or consulting, or participate in the “gig” economy, or launch a passion project. “Retirement” doesn’t have to be an old-fashioned, binary, from-this-moment-forward-I’m-not-going-to-earn-a-single-dollar straitjacket.
– Move to a country where the cost-of-living is cheaper. Try it for 6 months. Your worst-case scenario might be that you’ll spend the winter living on a tropical beach in Thailand or learning the local cooking techniques of Bali.
– Plain ol’ fashioned cutting back at home. Remember 2008? Remember how the “national mood” was one of frugality? I’m guessing that if there’s a serious market downturn, the attitude from your friends and family will be, “Hey, let’s watch Netflix tonight instead of hitting the bars.” You don’t need to live this way forever. Trimming back during recessions will make the biggest difference, since you won’t be converting paper losses into real losses.
#2: Create a “needs” bucket and a “wants” bucket.
One insight that Dr. Pfau shared is that we need a minimum baseline of money to survive. These are “needs.”
We also want extra money to fuel our lifestyle. These are “wants.”
“Duh, Sherlock,” you might be thinking. Bear with me.
Traditional retirement planning — including the 4 percent rule — lumps money for both needs and wants into the same bucket. But that might be a mistake.
Think about it. Why would you combine these two buckets together, when one is critical and one is discretionary?
Why would you expose the same level of risk to money that’s earmarked for groceries vs. trips to Italy?
The 4 percent rule assumes that all your retirement spending — both needs and wants — come from your portfolio. It assumes the same risk exposure, regardless of spending goal. And it doesn’t look at rental property income or other passive income, nor does it account for side hustle, gig economy, freelance or part-time income.
Flaws everywhere.
Try this instead:
Earmark some of your investments (or other income) to cover your basic needs. Keep these investments (relatively) conservative.
Then earmark another section of your investments (or other income) to cover your wants. Take more risks with this, if you choose.
Here are a few examples:
Needs – Your net cash flow from rental properties
Wants – Extra money from side hustles and passion projects
Needs – Laddered bonds (spaced evenly across months or years)
Wants – Stock index funds
Needs – The 3 percent rule of thumb
Wants – That extra 1 percent. (You’re still withdrawing at the 4 percent rate, but you can cut back if you need to).
#3: Try a U-shaped stock model
This is a counterintuitive idea I’ve never heard before.
When you’re young, and retirement is far away, tilt your investments so that you’re more exposed to stocks and less exposed to bonds. (Okay, this is normal advice.)
As you approach retirement, rearrange your investments so that you’re less exposed to stocks, more to bonds. (Again, this is normal).
Here’s the wild card —
After you retire, start increasing your exposure to stocks again. (WTF?!)
The result is a U-shaped asset allocation model:
This is a huge departure from the traditional idea of constantly reducing your stock exposure over time, or keeping “your age in bonds” with the rest in stocks.
At first glance, this U-shaped concept seems counterintuitive. Your risk capacity — which is your ability to survive the rollercoaster of the market — declines as your timeline shortens. Less time; less capacity for risk.
So why would you accept MORE risk after you retire?
According to Dr. Pfau, this U-shaped model works mathematically because your timeline and risk capacity aren’t exactly hand-in-hand. “Risk capacity” is your ability to endure a market drop without compromising your lifestyle. Once you’ve made it past those critical first few years of retirement — assuming no major traumas at the onset — your portfolio could be strong enough to handle bigger swings.
Hmmm. This is a fascinating idea. I’m not sure if I agree with this or not, but I’ve never heard anything like it before, and the logic makes sense. I’m introducing it here as interesting food for thought.
TL;DR — The 4 percent rule-of-thumb might have flaws, but it’s still excellent for retirement planning, as long as you’re flexible. Flexibility is the only real security.
And when all else fails, move to Thailand.
Or get a job.
(Nahhhh.)
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While I of course don’t want to go broke in retirement, I also don’t feel the need to keep my portfolio intact or growing up until the day I die, and the 4% rule seems intent on NEVER drawing down the principle of the retirement funds. That’s my biggest problem with it.
I do find this idea appealing – shifting more conservatively to get me through the first 10-15 years of retirement (and sleeping well during downturns), and then if I feel like it, investing for growth before I die. I’d love to see someone run some numbers – FourPillarFreedom has been doing TONS of data work, maybe he’d be game.
Yes, the 4 percent withdrawal rule is based on the worst-case-scenario from 1926 through the early 1990’s. This means that within every other scenario — anything other than the absolute historic worst-case — a person could withdraw more than 4 percent.
That’s why I’m sometimes surprised when people say the 4 percent rule is too conservative. I understand that they’re worried that the future might not be as strong as the past … but that’s also balanced by the fact that 4 percent represents the worst-case-scenario of the past.
I like the approach of being more conservative at the start, due to sequence-of-returns risk, and then amping up later on. That makes sense to me!
I’m chugging along at a budget of 4.79% WR. But I come in under budget every year so I’m actually real close to 4. I think I’m going to be OK. I like the idea of a “fun” side job. Like maybe part time usher at a live music venue. Minimum wage plus free concerts. Yes, please!
‘Fun” side jobs are the best. You meet people, find out about the behind-the-scenes of new places, and there’s zero pressure to actually make any money. Your paychecks are a bonus, rather than the focus. 🙂
I enjoy listening to Pfau since he adds a critical-eye perspective to the dogma out there in the FIRE community. But I’m also pretty conservative anyway, so I’m not going to use 4%. I’m already positioned at 3% and hoping to get it to 2.5% within a few years.
Wow, that’s very conservative! At the end of the day, the most important thing is having the self-knowledge to chart a course that’s sustainable over the long-term. It sounds like you’re doing that! 🙂
I think I like this concept of increasing risk in retirement. My portfolio would be large anyway in case there was a dip (and I could always do something on the side, like was mentioned) and I think the risk would be worth it since there would be greater potential for higher returns and then I could leave even a greater legacy for my family (and travel more 🙂 ).
Wes Moss attempted to re-create and update Bengen’s study; https://www.wesmoss.com/news/the-new-verdict-on-the-4-rule-for-retirement/. In the article he seems to conclude that 4% is still about right given additional historical observations. However, on his show he seems to be slightly more aggressive.
I’m trying for 3.6% since it is $3K/month/$mil, but as an active reluctant early retiree, I’m having trouble with it.
You’re a reluctant early retiree? What happened? Hope it’s okay ….
I don’t know what happened to cause Sherry’s “reluctant” early retirement, but I was sidelined by health issues. I worked into my early 60s, even changing careers in a new country where I had no work history. I thought I’d found a path where I could work full- or part-time for many years. Then I discovered that I had developed substantial arthritis in my hands & wrists. Any work that required a keyboard was off the table. My story isn’t unique, so I’m always sceptical of advice to “work longer” or get a “side gig.” Sometimes, you. just. CAN’T.
Your creative thinking Paula is spot on! My mind is also quite open to trying different things, hopefully my older self agrees 🙂
Hi! What “different things” have you tried recently, I wonder?
Good article. Really.
FIRE is good and also dangerous. FIRE can easily leave someone at the mercy of life and financial markets for 50 or more years. A half century is a really long time. Lots of stuff can happen or will happen and much of it will be ‘undesirable’.
Yes, a bad stock or bond market can happen and the recovery period can be a long time. There have been 2 long periods of financial market distress in the last 100 years, the one you mentioned and the entire 1930s. But there are also other things that can happen:
— The divorce that takes half your wealth
— The crippling disability that drains savings
— A different disability that makes employment not possible
— Children that need meaningful financial help
— Non financial investments that go bad (the rental property turns into a bad neighborhood and value and rents drop)
— And on and on…
And for half the population that doesn’t have the super high IQ, a job hunt 25 years after retirement means being a greeter at WalMart (if it even exists). Not a good path to recovery.
As someone who did FIRE at 50 some 20 years ago, my opinion is that the retirement path should be one of caution and layers of ‘defense’. If 4% is the rule, then be able to fall back to 2%. Own your home, in a state that limits taxes on seniors, and fixed expenses are basically food.
Layers include things like:
— Making sure you qualify for full social security
— Spending 20 years getting a pension (maybe with medical)
— Always own a business (could/should be 80%+ passive)
— A deferred annuity (post age 75-80)
— Alternative investments like real estate participations
— And on and on…
You don’t need a lot of ‘layers’ but you really, really need some. My point is that a 50 year retirement plan that assumes that everything will go well so only a simple plan is needed isn’t really a plan or realistic. We always hear about success and lottery winners. The lottery losers just disappear. We never see them unless it’s ourselves or our family.
Not much is worse than being old, infirm and poor.
Thank you for this comment. While I do admire the optimism of early retirees, there is scant discussion about the things that can have a catastrophic financial impact on someone’s long term plans to live off their accumulated wealth.
Bob,
Well said!
Thanks for pointing out the other “life events” that can impact or even derail your plans.
I would love to see models/projections around the U-Shaped Model… it sounds fascinating and makes sense in a way, but like most plans, it would need flexibility depending on the current market and financial situation.
And #1 seems like the “rule” that should underlie all other rules. Add flexibility to the mix and many of the worst case scenarios seem not-so-worst-case.
Exactly! JL Collins said it best when he said that flexibility is the true source of freedom and security. 🙂
Big ERN at early retirement now has looked into this idea but he illustrates the it in a different graphical manner.
See here:https://earlyretirementnow.com/2017/09/13/the-ultimate-guide-to-safe-withdrawal-rates-part-19-equity-glidepaths/
Flexibility really is the key. Controlling the things you can control, like expenses, and letting go of the things you can’t, like Ms. Market. If you exercise that control there will be years where you might take 6% and year where you take 2%. Learning to live within those lines is the magic.
Also, the 4% rule was meant for a 30 year retirement, not a 50 or 60 year retirement. There is no data to establish the idea that at 4% a portfolio would last through the lifetime of someone who took the RE portion of FIRE seriously.
I don’t know why nobody in the FIRE community has taken it upon themselves to forecast the 50 year model yet. Bengen’s study, as far as I know, was not overly sophisticated or complex with Monte Carlo analysis and such. It literally just took Point A to Point B with a beginning assumption of the asset allocations and came to a result. No reason Point B could not just be extended another 20 years to get the FIRE result.
Maybe in some of my down time after tax season I will take a look at that.
I believe http://www.FIREcalc.com does the modelling for longer than 30 years. Cool calculator to play with if you haven’t tried it.
That’s slick! Thank you!
Wade Pfau said in an interview with Mad Fientist to withdraw at 3.7, I think, for a longer than 30-year retirement. I’ve been meaning to re-listen to it to be sure
I remember listening to this podcast, thanks for recording – always interesting to hear a different perspective when discussing one of the sacred cows of the FIRE community.
I’ll go straight to your TL;DR – the 4 percent rule is simply a ‘rule-of-thumb’. Given that we can’t see the future, retirement planning can be extremely difficult given the number of variables we may encounter. I think having a few different strategies at work and a Plan A, Plan B, Plan C (e.g. rentals / side hustles etc… is the best position to be in when entering retirement because if the future doesn’t turn out exactly as anticipated you just let one of your backup plans kick into action.
HH
It’ll be interesting to see how the 4% rule holds up given the elevated market multiples we’ve been experiencing. And totally ageee with the earlier commentator on being subject to the whims of the market for 50+ years does not perfectly encapsulate the original study. Now, combine that with the possibility of longer life spans and you’ve got some real unknowns on your hands.
In 1929, the market lost 90% of its value, and the 4% rule still worked. Sure, the future could be worse than that past, but we’re almost talking zombie apocalypse scenarios.
Anytime you get in a car you could be killed by a drunk driver. Or if you don’t leave home, you could slip and die in the bathtub. There is simply no way to have perfect security. In this case, improved security requires that you work extra years, or have a reduced lifestyle in retirement. Those are very high costs for a very small theoretical improvement in safety.
If you do think the future might be worse than the past, a more rational strategy is to have a reduced lifestyle for a few years, until you get past the critical initial withdrawal phase and then don’t worry about it.
I’ve achieved financial independence, but in order to achieve my true financial goals (being a billionaire) I need to start and build a successful business. Saving and investing is the get rich slow method. I’d rather build a hockey-stick growth business with exponential scale.
How U-shaped stock model work for the retirement can you please explain it briefly.
How it would work:
When you’re far away from retirement, you have a large chunk of your investments in stock funds. (The top left of the U)
As you approach retirement, you have fewer and fewer investments in stocks. (The bottom of the U.)
After retirement, you start gradually increasing your stock exposure again. (The right side of the U.)
That’s the idea behind the U-shaped model.
If you dig into the fine print, you’ll see Wade Pfau work assumes a 1% cost due to fees, which Bengen neglected. Hence the SWR goes from 4% to 3%. Since Vanguard and others charge as little 0.04% or sometimes even less for an index fund, we can safely ignore Pfau’s advice on this topic.
Remember, 4% was the worst case scenario. In most scenarios, at the end of 30 years you wind up vastly wealthier than when you started. The key to success or failure is avoiding a poor sequence of returns early in your retirement. So by all means be flexible and smart in the early years, especially if your portfolio isn’t doing well. If by about year 10 you still have your initial balance (again, in most scenarios you will), it will be smooth sailing as far as the eye can see.
Pfau sells product by selling fear and doubt, and making simple things look complex. It isn’t complex: 4% and a small dash of common sense. It really is that simple.
i think it’s important to really differentiate want and needs. i just did this a couple of months ago and came up with 3 tiers. the absolute needs were housing, food, utilities, and basic clothing. tier 2 is common comforts that you might not want to go without like a car, tv, cell service, and internet. tier 3 is absolute frivolous luxury like travel, booze, pets, gifts. it was instructive to know how much we in our house needed to just “survive.” it came in around 50% of our typical spend. i know i left out health insurance for now as i’m still working.
i’m willing to take more risk with the investments dedicated to tiers 2 and 3. worst case is that we’re having cheap wine and the dog eats sunshine chunks instead of iams. we’ve also considered leveraging our house as by renting a couple of rooms as a nuclear last resort option.
interesting post and i agree with an earlier comment about never spending principle. we don’t have offspring and i think i’ll write into my will that if the beneficiaries are getting anything then we screwed it up!
I couldn’t agree more. It’s also important to note that in a downturn, you will likely be surrounded by friends and family who are also tightening belts so this will feel natural and a little easier as well. There will be less spending all around. “Wants” will be examined closely in a bad economic situation so it makes sense to plan for it – the first things to suffer are “luxury” items like eating out, buying organic, getting hair/nails done, massages, vacations outside the US, etc. I like the idea of having a Plan A, B, C and D. Plans A, B, C being increasing degrees of belt tightening and D being the nuclear last resort option.
May we assume that you are a healthy eater, (maybe even a vegetarian) with a holistic approach to food and heath?? I ask because I seem to meet more and more seniors who are slave to way too many prescription drugs, ( a tier unto itself, really). These drugs cost an arm and a leg – super unfortunate state of affairs in this first world country.
It would be helpful to read Bill Bengen’s original article.
http://www.retailinvestor.org/pdf/Bengen1.pdf
Bill Bengen recently did an interview on Reddit. And people quizzed him about the 4% Rule.
https://www.reddit.com/r/financialindependence/comments/6vazih/im_bill_bengen_and_i_first_proposed_the_4_safe/
When you read the interview, you see there are so many assumptions. Stock/bonds mix, timeline, inflation, stock market returns. All in all, he still backs his 4% rule, more or less, depending on how long you want your money to last.
What a great article. Thank you very much. I’m at the tail end of my career (I’m 44) and have been looking into retirement allocation. The good articles are few and far between and this one is one of the best ones written.
Your perspective on needs (at 3%) and wants (at 1%) is a fresh take and I must say I really like it.
Another one that I really liked: https://retirehappy.ca/can-we-retire-rules-of-thumb/
Don’t let the title fool you. He actually debunks a lot of the rules of thumbs, including the bonds/equity ratio one should have in retirement.
An interesting article because it introduces the idea of the U-shaped model for investing. I hope it is sufficient to encourage people to look into this further by researching to identify the pitfalls and other aspects of living to make this successful.
I chose this approach in the early 1990’s when hardly anyone would hire a “redundant declared” 50+ years old business admin executive. I’ve been on a wild ride since, and still riding it today, with my current financial position on a net worth basis almost the same I started with. My mix of investments has changed dramatically from being about 85% in equities to the current 40% as my home has steadily grown in value whilst the rest has been shrinking. As it is, my last long-term budget has me lasting another 20 years. In hindsight, I’ve not done it perfectly, and I am benefiting from that in my plan for the next 20 years. Here are some basic principles I followed.
– Planning is the key, Your chances in life are greatest that you will end up where you plan to be.
– Flexibility is next. If planned earnings of XYZ come in at XY, then your spending of XYZ has to be adjusted to XY. Repeat in all aspects of life.
– Courage to face the present and your best options for the future, then embrace it all.
– Learning has to keep pace with how the world changes, as it does at a tremendous rate.
– Balancing, in every part of life, not only does it serve you well, it will shelter you from extremes.
– Opportunities can’t be planned, but must be evaluated and acted upon when they appear.
– Share some of your free time, your good fortune and your knowledge. It’s a good investment.
Take that U-Turn, and enjoy!
Nice balanced commentary on the safe withdrawal rate Paula! I personally have followed 3% with 30 X savings. However I know it’s not realistic for some. So flexibility and side-hustling is the way to go
The biggest counter intuitive thing that I see is that people assume bonds are safe.
1month yield on the US treasury curve is 1.74%, the 10 year is 2.89%, and the 30 year is at 3.04, I know if I buy bonds today, NONE of those yields would go up.
If I buy the S&P 500 the yield is 1.9% and has a tendency to grow over time. As an example, its up 40% (give or take) since 2006. so over time it grows.
When we look at any of these studies, that developed the 60/40 equity/bond ratios, or the 4% rule, it all assumed a 5% or more average
Personally I see 0 reason to buy bonds in this environment. IMO the most risky investment IS bonds. There is no reason to have any bonds in your portfolio.
Maybe I am suffering from old man disease and remember getting a great rate on a variable rate home loan of 10.6%. I remember CD’s at 15% and 16%. and COLA’s of 17-18%.
I kinda wonder if a lot of this research on equity/bond ratios wasn’t developed as rates were moving from 18% to 1 or2%.
I followed all the advice I got when I was 26 and invested fully in all subsequent years my max retirement. About 5 years was spent not making deposits because I had no plan, and the biggest mistake I made was drawing out 15k to keep from losing my house in 1994. In retrospect, I should have just abandoned my 3% down and waited 7 years for it to fall of my credit. As it was my late payments screwed my credit anyway, you don’t get any benefit from paying people off. So I’m not doing too bad, but after 25 years, i’ve only got 570k in retirement funds. I have about 200k in my house. Had I not started renovating houses and renting them I’d be PHKD. I do mostly commercial, and now I get 10k a month in passive income. It was difficult! My best advice is don’t rent to anyone slightly sketchy, even if you’re desperate, eat your blood instead. Anyway, now that the worry of not having enough is removed, I cannot believe how bad the market has been …. chopping off my legs in 1999, 2008. That going forward shrunk my gains. Had I not made incredibly aggressive investments, I daresay I’d have 200k instead of 570k. I’m supposed to have over a million according to the doofus investment advisors right? Where TF is is? I had one place I worked put my money into government money market. It was only $150… but after ten years, they returned $137 to me last year…. from 2008 to 2018 they lost money in a money market. Those advisors should be horsewhipped.