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The 4% Rule: great in theory, not in practice

by Feb 11, 2020

Before retiring, I read a lot about the ‘Safe Withdrawal Rate’. I created lots of Excel sheets to check whether the mythical 4% would work for us.

Apparently, it would. Happy days!

Then we actually retired, and we learned that at the same time, the “safe withdrawal rate” works, and it doesn’t.

Bill Bengen and the 4%

(I just wrote this headline and thought: if I ever learn how to play the guitar, I’ll start a Rock’n’Roll band with some others retirees, and we’re going to call ourselves “Bill Bengen and the 4%”. 😜)

Beside making for a great Rock’n’Roll band name, Bill Bengen and the 4% are forever linked in the mind of early retirees. In 1994, this (then) unknown american accountant crunched lots of historical data, and calculated that the ‘safe’ withdrawal rate over 30 years is 4%.

Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe.

Bill Bengen

Father of the 4% rule

What about 5 or 6%?

Bengen also checked other rates, before settling on 4%:

  • 3% (or even 3.5%) was found to be an ‘absolutely safe‘ rate, as every retiree would not run out of money for at least 50 years.
  • 4% would make money last for at least 33 years.
  • 5% would work in many scenarios, but not all. For example, people beginning their retirement in the late 1960s and early 1970s would have only preserved their money for 20 years due to market crashes and other economic events.
  • At 6%, a good 60% of retirees would run out of money before 30 years.

There are a few notes and caveats in Bengen’s paper, most notably:

  • Bengen’s goal was to avoid running out of money within 30 years. So, ending with a portfolio worth just $1 on year 31 was considered a success. This could be risky for early retirees who may want for their money to last for 40 or 50 years (or more, hopefully đŸ€ž)
  • Tax is not considered in this study, so the income is gross and tax payments may reduce it.

The Trinity Study confirms Bengen’s findings

In 1998, three professors from Trinity University, Texas, published a study (“Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable”) which was very similar to Bengen’s, although it looked at which probability different withdrawal rates had to make money last for 30 years.

That sounds confusing, so let’s cut the chase: did this study confirm Bengen’s findings? Yes, more or less. According to the Trinity study, a 4% withdrawal rate has a 95% chance of not running out of money in 30 years (which increases to 98% if the portfolio is 75% stocks).

Why 95% instead of 100%, as Bengen found? The difference is probably explained by these two factors:

  1. The trinity study used longer historical data (from 1926 to 1995)
  2. The type of assets used is slightly different: Bengen used Treasury Bonds; The Trinity study used Corporate bonds.

Independent researchers confirm the Trinity Study

In 2009, a researcher named Wade Pfau replicated the Trinity study, using even longer historical data: 1926 to 2009. He wrote:

I think people are sometimes curious if [Trinity’s] result may have changed if the study were repeated today, especially in light of the recent financial crisis. The simple answer is: no.

According to Pfau, the extended data places the probability of success of the 4% withdrawal rate at 96%, 1% more than the Trinity study.

In 2011, the Trinity team updated their own research. They confirmed Pfau’s findings (96% success rate for a 4% withdrawal rate), and also calculated this would increase to 100% for portfolios which have 75% shares.

Bengen improves the 4% rule with a flexible approach

Bengen himself, updating his research in 2001, introduced a twist to his own 4% rule. Instead of a fixed 4% withdrawal, he suggested using a variable amount based on the previous year’s market returns. This approach, which he called “Floor and Ceiling system”, would work like this:

  1. You make your initial 4% withdrawal. Say, $40,000.
  2. In a bull market, the next annual withdrawal can be 25% higher ($50,000)
  3. In a bear market, the withdrawals will be 10% lower ($36,000).
  4. In both cases, the increases (or decreases) are calculated on the initial withdrawal adjusted for inflation.

This approach, according to Bengen, increases the safe withdrawal rate to 4.58% for 30 years.

In a recent and very interesting Reddit AMA (Ask Me Anything) he commented:

The average safe withdrawal rate […] is, believe it or not, 7%! However, if you experience a major bear market early in retirement, as in 1937 or 2000, that drops to 5.25%. Add in heavy inflation, as occurred in the 1970’s, and it takes you down to 4.5%.

7%?!Â đŸ˜± Before you start popping the champagne and dream of a long rich early retirement, please note that Bengen also added:

As your “time horizon” increases beyond 30 years, as you might expect, the safe withdrawal rate decreases. For example for 35 years, I calculated 4.3%; for 40 years, 4.2%; and for 45 years, 4.1%. […] If you plan to live forever, 4% should do it. 

In theory, theory and practice are the same. In practice, they are not.

– Albert Einstein –

The Family’s take on the 4% rule

I’ve spent quite a bit of time reading the research and crunching the numbers, and I can say I totally buy the reasoning and the results. But as usual, one thing is the theory, one thing is the practice! Now that we have ‘retired’, and we have to live off our savings, our view is slightly different.

Withdrawing 4% of our capital feels like withdrawing a lot of money, especially as we do this at the beginning of the year, when we still don’t know how the market will perform. It feels like moving a big chunk of money from the ‘productive’ side (ie the one where money can grow), to a non-productive one.

4% doesn’t feel safe

We consider Bengen’s 4% a sort of upper limit, something we never want to go above. For our retirement we are targeting a 1.5% rate, so we can still double that and land on 3%, which is considered ultra-safe anyway.

In a way, it feels like standing on a cliff, where someone has painted a white line on the edge – “Don’t go past this point”. Although we ‘get’ that standing on the line is safe, we want to be one meter inside of it!

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