Longevity risk is an area of uncertainty that frequently arises relative to retirement planning, so one of the most common questions we hear from new clients is, “How can I be reasonably certain that I will not outlive my retirement savings?” At Baker Wealth Strategies, we start with the 4 percent rule. So, what is the 4 percent rule? It’s a strategy and methodology with a clear aim: to calculate how much a person can withdraw from their retirement savings so that they do not run out of money before they die.
Today’s article is a historical, technical, and practical primer on the 4% rule, as well as the present conditions that financial planners must account for to deliver results.
The “4 percent rule” popularized and simplified retirement planning.
It has been 30 years since the publication of William Bengen’s seminal 1994 article in the Journal of Financial Planning. Bengen examined historical returns data for a portfolio of stocks and bonds and determined the optimal withdrawal rate, one that would be sustainable over a 30-year retirement.
So, what is the 4 percent rule in its simplest terms? Bengen proposed a withdrawal equal to 4% of a retiree’s initial portfolio value with annual increases for inflation and concluded that a 4% withdrawal rate is a sustainable rate that would not deplete a retiree’s savings over 30 years. His novel approach to retirement portfolio analysis helped to boost public awareness of retirement planning and was subsequently dubbed the “4 percent rule,” although Bengen did not call it that.¹
Retirement planners must identify and correct outdated assumptions, both technical and cultural, to produce workable models.
Bengen used stock market investment returns from 1926 to 1974 to determine whether a fund retiree would run out of money, assuming varying withdrawal rates and various retirement dates during that period. His analysis also accounted for periods of economic upheaval, such as in 1929, 1937, 1965, and 1966.
Today, it’s not that simple, or perhaps it never was.
Market catastrophes affect all retirement accounts but not uniformly.
Bengen ran his model in the first years of the worst bear markets of the twentieth century to account for risk, specifically sequence of returns risk.
A 50/50 split between stocks and bonds would severely underperform in 2024.
There is virtually no scenario in which a 50/50 split would be appropriate for a client. Now, allocation strategies may vary significantly to align with a client’s aversion to risk, but we cannot forget that the point of creating and managing a portfolio is to produce substantive returns on investment; a 50/50 split would not produce those returns.
Bengen was aware that his portfolio strategy was bond-heavy. At that time, growth stocks were not driving the market as they are today, and bond interest rates were substantially lower (I expand on this point below).
“Does that mean that a 50/50 mix is optimal for all situations during retirement? Not at all. For all withdrawal percentages, the bars for 50-percent stocks and 75-percent stocks are very close in height…From the perspective of the highest minimum portfolio longevity, that means you give up very little by increasing stocks from 50 percent to 75 percent of the portfolio. But do you gain anything in return?”²
Again, we’re looking at charts from 1994. Business owners are getting younger and younger, and clients’ risk tolerances are essential to retirement planning.
Legacy goals and safe withdrawal rates must be incorporated into present-day applications of the 4 percent rule.
Clients who have a desire to pass assets along to subsequent generations must keep in mind that Bengen’s analysis did not factor in legacy goals.
“In addition, I point out that in most cases, even if he is outlived by his money, there may be little to pass on to heirs. If this is a significant consideration to the client, it may cause him to look at a more conservative drawdown, at least in the early years of retirement.”²
Retirees—and those planning for retirement—are in debt to Bengen for developing an analytic framework to determine portfolio withdrawal rates. However, the framework does not account for passing retirement assets along to children and/or grandchildren.
A flat 30-year life expectancy is no longer a viable metric.
Between 1994 and the present, the average life expectancy in the United States has increased from 74 to 80, approximately.³ Keep in mind that “average” includes all socioeconomic classes and income levels, and wealthy individuals live longer on average than low-income individuals.⁴ For high-income clients, the average is likely short by a number of years.
“I point out that the chart shows 31 scenario years when he would outlive his assets, and only 20, which would have been adequate for his purposes (as we shall see later, a different asset allocation would improve this, but it would still be uncomfortable, in my opinion).”²
Different asset allocation strategies may have been uncomfortable in 1994, but today, as I explained earlier, asset allocation strategies have changed. Individuals live longer, and medical technology accounts for a statistically significant portion of those additional years. Medicine is also expensive. How do financial planners respond?
Retirement planners should account for the good and the bad that come with increased longevity.
First, financial planners must earn the trust of their clients and push for closer relationships. I am aware that “close relationship” is cliche, so allow me to clarify: “Close” means candid and sincere rapport, not ten-minute meetings and annual performance reviews.
Second, retirement planners should use earned trust to learn as much as possible about their clients; trust is a prerequisite for retirement planning that is narrowly tailored to the issues that come with advanced age, including health and lifestyle issues.
Third, advancements in the practice of medicine extend life expectancy, which informs retirement planning. So, is it unreasonable to look for deeper insights?
The field of genomic medicine is maturing, and if we can factor in hereditary conditions and predispositions such as Alzheimer’s and heart disease, we have to confront the fact that costs associated with long-term care, whether at home or in a facility, are cost-prohibitive for many retirees and continue to increase.
Inflation was lower than we have experienced recently.
Bengen may have reconsidered the underlying thesis of his first paper if he had written it within the last fifteen years. Of course, we’re going to see inflationary periods. Still, when we have an inflation rate of 2.4%, it’s a significant decline, so we have to update our planning. Retirees prioritize passing wealth to families and charities.
Bengen’s paper does offer some guidance on legacy issues.
“If they wish to leave some wealth to their heirs, their expected “portfolio lives” should be somewhat longer than that…What if a client feels he requires larger withdrawals? For example, a client with a $400,000 portfolio would like to withdraw $24,000 the first year and then increase it with inflation each year. This is a six-percent withdrawal rate for the first year. I show the client the chart for 6-percent withdrawals and explain the risks of such an approach (assume for now that the client has a 50/50 stock/bond allocation.”²
This is partly true, but Bengen was certainly aware that his 4 percent rule is individual rather than family-based.
Bengen’s analysis does not account for behavioral finance issues.
The psychological impact of seeing account balances falling and rising should always be considered, and there are strategies to keep retirees on the correct path as they experience declines.
“My research indicates strongly that as long as the client’s goals remain the same, there is no need to change the initial asset allocation. It is likely to do more harm than good, as we shall see.”²
That’s easy to say to a retiree, but it’s likely neither a sufficient explanation nor an appropriate bedside manner. Today, we have options and flexibility to deliver returns even if a client’s risk tolerance wanes.
Is the debate between 4.5% or 5% necessary for retirement planners?
For most of the last 25 years, the United States has experienced high market valuations, and inflation has been low since the Great Recession.
In Bengen’s 2020 paper, he found that, in a high-valuation, low-inflation scenario at the time of retirement, a 5% initial withdrawal rate was sustainable over 30 years.⁵
So, he suggests that retirees can make larger initial withdrawals under certain circumstances, but those circumstances have changed. The current market valuation is high and is working its way back to 2020 levels. It’s higher than any of the scenarios in Bengen’s research, which would call for a withdrawal of 5% with inflation between 0% and 2.5%.²
Now, in the present, we see financial planners, or at least those who debate one another in public forums, divided into two camps of opposing and equally speculative opinions.
Opinion #1: If valuation drops near the historical mean, a withdrawal rate of 6% would be sustainable so long as inflation does not surpass 5%, which it will not.
Opinion #2: If valuation increases and inflation surpasses 2.5%, a sustainable rate would be closer to 4.5%.
To put this in plain English, some believe the rate should be higher because future returns will be higher. Others think it should be lower because returns will be lower. I take exception with both because “belief” has no business anywhere near your money and assets.
A good plan is built for change.
When we look at what the 4 percent rule means in today’s economy, we see it as a starting point for a more customized analysis of a particular retiree’s situation, but the calculations are more complex, and the model must be updated to account for assumptions and historical factors.
Our clients receive comprehensive plans for retirement with adaptability and flexibility baked in. While rules set standards and make financial planning accessible, experience, service, and expertise make financial plans successful.
Give me a call and let me know what you need.
– Justin Baker, General Counsel
Baker Wealth Strategies
References
- Bengen, William. “Reddit – Dive into Anything.” Reddit.com, 2017
- Bengen, William. “Determining Withdrawal Rates Using Historical Data.” Journal of Financial Planning, 1994
- United Nations, “World Population Prospects.” DESA, Population Division, 2024
- J., Cristia. “The Empirical Relationship Between Lifetime Earnings and Mortality” Congressional Budget Office, 2024
- Bengen, William. “Conserving client portfolios during retirement, Part III” Journal of Financial Planning, 2001
