Most Retirement Advice is Worse than Useless — Part V: 4% of Nothing

Image by Giga Paitchadze

My friend, drop all your preconceived and fixed ideas and be neutral. Do you know why this cup is useful? Because it is empty.
— Bruce Lee

Today we’re going to talk about the 4% rule. This little nugget is so widespread among personal finance sites as to be nearly ubiquitous, in one form or another. If you recall from part I, it’s the rule we used to determine how much money we needed to accumulate to meet our retirement goals.

Simply stated, the 4% rule is as follows: When it comes time to retire, multiply your nest egg by 4%. This amount constitues your “safe” withdrawal rate. In other words, it’s the amount you can supposedly withdraw every year, adjusting for inflation along the way, without worrying about running out of money during your lifetime.

It’s easy to see why this little rule of thumb is appealing. It’s simple, and it offers the prospect of a steady, predictable retirement income. The trouble is that the 4% rule is highly misleading, in large part because of these exact two features.

Hidden Assumptions Strike Again

If you stop and think about it for even a minute, surely you will begin to suspect that such a one-size-fits-all rule is unlikely to be reliable. The truth is, the 4% rule relies on a number of assumptions which are questionable at best. That’s because its popularity arose primarily out of a series of research studies from the ’90s that relied on very similar premises. One of the better known examples is the Trinity Study from 1998.

Don’t get me wrong, by the way. I’m not slamming the Trinity Study, or any of its counterparts. They were fine research studies and excellent contributions to the science of financial planning. My problem (which I’m confident the studies’ authors would share) is with the widespread misunderstanding and misapplication of their conclusions.

If you’d like a thorough treatment of the subject, check out this article. I’ll just summarize the key points.

Assumption 1: Your Retirement Will Last 30 Years

All of the main studies that originally gave rise to the 4% rule assumed a 30 year retirement. The Trinity Study, for example, predicted a 95-98% chance of not running out of money in 30 years following the rule.

The first and most obvious question is, what if 30 years isn’t long enough? People are living longer and longer, after all — and what if I want to retire early?

A slightly less obvious but equally valid question may be asked from the other direction. What if my likely lifespan is less? What if I’ve had a much longer career and am looking to retire at age 80? Can’t I reasonably spend a bit more, and hit the golf course a bit more often without worry?

Assumption 2: You Want to Die Broke

The next assumption is that you don’t care if you consume your entire next egg, so long as you have enough to last for those 30 years. Now this may well be true for many people. Economists would also argue that it’s the most efficient use of resources. But is it really what you want?

If you care about leaving an inheritance for your kids, for example, you may not want to adopt a strategy that won’t be likely to leave much behind for them. Or perhaps you would like to set up a charitable trust with your wealth when you die, which can benefit your favorite cause more or less indefinitely. Again, you’ll want to preserve your wealth rather than spend it down.

If you’d rather the last check you write before you kick the bucket bounce, that’s perfectly fine with me. Just be sure your plan reflects your choice.

Assumption 3: You’ll Invest in U.S. Securities and Achieve Average Results

The studies generally assume a static mix of U.S. stocks and Treasuries, and investment results that match the indices with no accounting of fees, expenses, or taxes. If this doesn’t send off multiple alarm bells in your head, I urge you to reread the earlier installments of this series, particularly part IV.

Assumption 4: You’ll Require the Same Inflation-Adjusted Income for Your Entire Retirement

This assumption is absurd on its face. Chances are that some of your expenses will go down as you age. Others, like health care, will most likely go up. Way up. Then again, maybe the U.S. will switch to single payer health care 20 years from now, and you’ll no longer have to worry about it. Who knows?

The one thing you can say with confidence is that your expenses are highly unlikely to remain perfectly stable across your entire retirement. So any plan that assumes they will is suspect.

Assumption 5: Future Market Returns Will Resemble the Past

You’ve all heard the mantra that past performance does not necessarily predict future results. Most everyone will agree that this is a truism when it comes to analyzing individual stocks. The thing is, it is equally true for broad market indexes.

In truth, there is absolutely no way to know whether the next 30 years of stock returns will resemble the past 30, and there is significant reason to believe that they won’t. In order for historical returns to continue for broad market indexes into the future, our economy will have to continue to grow exponentially over time.

The world of finance offers few certainties, but I can state one with 100% confidence — our economy will not grow exponentially forever. It is physically impossible on a planet with finite resources. One day, growth will cease. It may happen during your lifetime, and it may not. But it will happen, and if you know anything at all about the exponential function, you know that it could run up against its limits far more quickly than most people realize.

Assumption 6: The U.S. Will Maintain its Overwhelming Economic Dominance

Even the nightmare scenario of reaching the limits of the planet’s ability to support our consumption is not necessary for the 4% rule to break down. All that is required is for the future returns in the U.S. to look more like the returns in other developed countries. Consider this study by Wade Pfau in the Journal of Financial Planning. Here’s a telling quote:

From an international perspective, a 4 percent real withdrawal rate is surprisingly risky. Even with some overly optimistic assumptions, it would have only provided “safety” in 4 of the 17 countries. A fixed asset allocation split evenly between stocks and bonds would have failed at some point in all 17 countries.

In short, the U.S. has had an extraordinary run of outsized growth over the past 130 years. You cannot safely assume that this will continue in a rapidly globalizing world. If the future growth of the U.S. slows just enough to match the historical growth of other developed, first-world countries, the 4% rule turns out not to offer much safety at all.

Reality for the Win (Again)

There’s a great deal more to say on the shortcomings of the 4% rule, but I’ll leave it there. If you require more convincing (and good for you if you do — you’re learning), I encourage you to read the article I mentioned earlier. It was the source for many of the facts and figures I have relied on here.

The ultimate takeaway from all of this is much the same as for the previous entries in this series — you’re going to have to be ready, willing, and able to adjust your strategy over time based on events in the real world. There are a couple of relatively simple ways to do this reliably, which I will discuss in a later article, but the crux of the matter is that you’ll need to cultivate a willingness to embrace uncertainty, and build resiliency. A significant safety cushion couldn’t hurt, either.

It is troubling that so many people rely on such a spurious metric when making their plans. Don’t be one of them.

13 Comments

  1. OK, Sean….

    …you’ve got me out on the window ledge.

    The good news is coming when…?

    • Sean Owen

      What’s the old saying about a good scare being better than good advice? ;)

      That is the last of the “worse than useless” series for the time being, though. The next series will be on actions to take. And there will be good news there, for those who are willing to do what it takes.

      • looking forward to it.

        great job on this series, Sean.

      • I hope so. You stated:

        “you’re going to have to be ready, willing, and able to adjust your strategy over time based on events in the real world.</i?

        and that is something i view as one of my advantages with a 3% safe withdrawal rate, so please don't rain on my parade… :(

  2. Tim

    After reading this entire series, I’d be interested to know what your retirement plan consists of.

    • Sean Owen

      It consisted of a lot of mistakes, missteps, and misjudgments, sprinkled with a dangerous mix of ignorance and hubris, for more years than I would care to admit.

      Now it consists of vastly downsizing my lifestyle (which, far from making me feel deprived, actually made me happier), saving a minimum of 66% of my income, and investing in dividend growth stocks, individual bonds, and real estate.

      I’ll be talking about each of these elements at some length here.

  3. CK

    I’m looking forward to part 5….do you know when you’ll be posting that?

  4. CgK

    I’m looking forward to the next part. Have been for a few weeks now :)

    • Sean Owen

      Sorry for the wait! Have been working long hours these past few weeks. My enthusiasm for early retirement has its reasons, after all. ;)

  5. Thanks for the mention in your article, Sean. Much appreciated!

    • Sean Owen

      Thanks for stopping by, Todd. I’m a big fan of your site!

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