The 4% Rule for Retirement (FIRE) - YouTube

If you have spent any time researching retirement  

planning online, you have heard of the  4% rule. If you haven’t heard of it,  

the 4% rule suggests that if you spend 4% of  your assets in your initial year of retirement,  

and then adjust for inflation each year going  forward, you will be unlikely to run out of money.

To put some numbers to it, if you wanted to  retire and spend $40,000 per year, adjusted for  

inflation, from your portfolio, you would need to  retire with one million dollars to adhere to the  

four percent rule. This rule is alternatively  described as the requirement to have 25 years  

worth of spending in your portfolio to afford  retirement. 1/25 equals 4% - it’s the same rule.

While it is simple and elegant, the 4%  rule is probably not the best way to  

plan for retirement, especially  if you plan on retiring early.

I’m Ben Felix, Associate Portfolio Manager  at PWL Capital. In this episode of Common  

Sense Investing, I’m going to tell you  why the 4% rule is not a rule to live by.

The 4% rule originated in William  Bengen’s October 1994 study,  

published in the Journal of Financial Planning. Bengen was a financial planner. He wanted to  

find a realistic safe withdrawal rate  to recommend to his retired clients.

Bengan’s breakthrough in determining a safe  withdrawal rate came from modelling spending  

over 30-year periods in US market history rather  than the common practice of simply using average  

historical returns. Using data for a hypothetical  portfolio consisting of 50% S&P 500 index and 50%  

intermediate-term US government bonds he looked  at rolling 30-year periods starting in 1926,  

ending with 1992. So, 1926 – 1955, followed  by 1927 – 1956 etc., ending with 1963 – 1992.

The maximum safe withdrawal rate in the worst  30-year period ended up being just over 4%.  

From this simple but innovative analysis, the  4% rule was born. More recently Bengen has  

adjusted his spending rule to 4.5% based  on the inclusion of small cap stocks in  

the hypothetical historical portfolio. While  the 4% (and the 4.5% rule) may have basis in  

historical US data, there are substantial  problems with these rules in general,  

and specifically in the case of a  retirement period longer than 30 years.  

In his 2017 book How Much Can I Spend  in Retirement, Wade Pfau, Ph.D, CFA,  

looked at 30-year safe withdrawal rates  in both US and non-US markets using the  

Dimson-Marsh-Staunton Global Returns Dataset, and  assuming a portfolio of 50% stocks and 50% bills.

He found that the US at 3.9%,  Canada at 4.0%, New Zealand at 3.8%,  

and Denmark at 3.7% were the only countries  in the dataset that would have historically  

supported something close to the 4%  rule. The aggregate global portfolio  

of stocks and bills had a much lower  30-year safe withdrawal rate of 3.5%.

Considering returns other that US historical  returns is important, but, in my opinion,  

one of the most important assumptions  to be aware of in the 4% rule is the  

30-year retirement period used by Bengen.  People are living longer, and many of the  

bloggers citing the 4% rule are focused on  FIRE, financial independence retire early.

In Bengen’s study the 4% rule with  a 50% stock 50% bond portfolio was  

shown to have a 0% chance of failure over  30-year historical periods in the US. That  

chance of failure increases to around  15% over 40-year periods, and closer to  

30% over 50-year periods. FIRE likely means  a retirement period longer than 30 years.

Modelling longer time periods using historical  sampling becomes problematic because we have  

data for a limited number of historical 50-year  periods. One way to address this issue is with  

Monte Carlo simulation. Monte Carlo is a technique  where an unlimited number of sample data sets  

can be simulated to model uncertainty  without relying on historical periods.  

Even with Monte Carlo simulation, there is an  obvious risk to using historical data to build  

expectations about the future. The world today  is different than it was in the past. Interest  

rates are low, and stock prices are high. While  it may be reasonable to expect relative outcomes  

to persist, such as stocks outperforming bonds,  small stocks outperforming large stocks, and value  

stocks outperforming growth stocks, the magnitude  of future returns are unknown and unknowable.

To address this, PWL Capital uses a combination  of equilibrium cost of capital and current market  

conditions to build an estimate for expected  future returns for use in financial planning. This  

process is outlined in the 2016  paper Great Expectations.  

Using the December 2017 PWL Capital expected  returns for a 50% stock 50% bond portfolio  

we are able to model the safe withdrawal  rate for varying durations of retirement  

using Monte Carlo simulation. We will assume  that a 95% success rate over 1,000 trials is  

sufficient to be called a safe withdrawal  rate. For a 30-year retirement period,  

our Monte Carlo simulation gives us a  3.5% safe withdrawal rate. Pretty close  

to the original 4% rule, and spot on with Wade  Pfau’s global revision of Bengen’s analysis.

Now let’s say a 40-year old wants to retire  today and assume life until age 95. That’s  

a 55-year retirement period. The safe  withdrawal rate? 2.2%. I think that this  

is such an important message. The 4% rule  falls apart over longer retirement periods.

So far we have talked about spending a  consistent inflation adjusted amount each  

year in retirement. One way to increase  the amount that you can spend overall  

is allowing for variable spending. In general  this means spending more when markets are good,  

and spending less when markets are bad.  The result is more spending overall with a  

lower probability of running out of money.  The catch is that you have to live with a  

variable income or have the ability to generate  additional income from, say, working, to fill  

in the gaps when markets are not doing well. We also need to talk about fees. Fees reduce  

returns. Fees may be negligible if you are using  low-cost ETFs, but they become extremely important  

if you are using high-fee mutual funds,  or if you are paying for financial advice.

The safe withdrawal rate in the worst 30-year  period in the US drops to 3.56% with a 1% fee,  

making the 4% rule the more like the 3.5% rule  after a 1% fee. Adding a 1% fee to the Monte  

Carlo simulation reduces the safe withdrawal rates  by around 0.50% on average. In both cases this is  

a meaningful reduction in spending. Of course,  fees need to be considered alongside the value  

being received in exchange for the fee. This  value should be heavily tied to behavioural  

coaching and financial decision making. There have been two well-known attempts to  

quantify the value of financial advice, one  by Vanguard and one by Morningstar. Vanguard  

estimated that between building a customized  investment plan, minimizing risks and tax impacts,  

and behavioural coaching, good financial advice  can add an average of 3% per year to returns.  

Morningstar looked at withdrawal strategies, asset  allocation, tax efficiency, liability relative  

optimization, annuity allocation, and timing  of social security (CPP in Canada), to arrive  

at a value-add of 2.34% per year. PWL Capital’s  Raymond Kerzerho has also written on this topic,  

finding an estimated value-add of just over 3%  per year. Based on these analyses, one could  

argue that paying 1% for good financial advice  could even increase your safe withdrawal rate.

I would not go that far, but the point  is that while fees are a consideration,  

they may be worthwhile in exchange for good  advice. Of course, if you can stay disciplined,  

take the time to educate yourself on  financial planning, keep up-to-date  

with tax laws and investment products, and  maintain your cognitive abilities into old age,  

you may be able to make your own good financial  decisions without paying a fee for advice.  

The 4% rule is a constant inflation adjusted  spending strategy. It may have worked over  

the worst 30-year period in US history, but  confidence in the rule starts to decrease  

when we consider international data, longer  retirement periods, expected future returns,  

investment fees, and the ability of  humans to make good financial decisions.

In a 55-year FIRE situation a safe withdrawal  rate might be closer to 2% before fees are taken  

into account. Fees are a consideration  in determining a safe withdrawal rate;  

all else equal, lower fees mean a  higher withdrawal rate. However,  

there are many financial decisions along the way  that could impact sustainable lifetime spending.

Have you ever thought about applying  the 4% rule to your own retirement?  

Has the information in this video made you  re-think? Let’s discuss it in the comments.

Thanks for watching. My name is Ben Felix  of PWL Capital and this is Common Sense  

Investing. I will be talking about a new  common sense investing topic every two weeks,  

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