Problems with the 4% Rule

Tina Haapala |

By Gary Silverman, CFP®

Last week I introduced the 4% rule when it comes to retirement. It means you could draw up to 4% of your portfolio your first retirement year and then, adjusting for inflation, keep that up for at least 30 years. Sounds great, but it has problems.

First, you may need your money to last more than 30 years. In cases of extreme market swings, your money could run out or even be at a surplus. There are two ways to cope with this.

The first is to begin by drawing out a smaller amount, say around 3.5%. That draw rate models around 50 years of draws with no problems. Or, you could not increase your draws if the markets don’t go up or even lower them if the market drops.

On the other hand, maybe you’re retiring later in life or have other monies to last you the first few years of retirement. In that case the 4% rule is too conservative. You might want a larger draw rate. A 5% beginning value will last around 20 years and give you more money to spend.

Another problem is that this assumes you invest your retirement portfolio in a balanced way. That means you’ve got about half your money in stocks (40-60%). If you have less than that, while safer in the short-run, your growth will suffer and the portfolio may not be able to keep up with inflation. If you have more, you are susceptible to a dramatic market decline early on.

Then there are taxes. When I say you can withdraw 4%, I’m talking about a pre-tax number. If your money is in a Roth IRA then your pre- and post-tax number is the same. If it is in a Traditional IRA, then you’ll have to pay Uncle Sam first and only get to spend the remainder.

Oh, and the 4% rule, it’s not really a rule. It is a guideline based on facts over the last 100 years. Different studies put the number somewhere between 3.5% and 5.0%. But what if the next 100 is very different?

Many professional publications and bloggers are questioning whether the withdrawal rate is set too high. They are worried because, while the historic long-term average on returns of stocks is around 10% per year, most predictions put the next many years at a 5-8% return. And as you can imagine, less return allows less withdrawals. So their logic is based on the idea that if a 4% draw rate is good with stocks returning 10%, you might need to drop things down to 2-3% if stocks are returning less.

While I do not doubt it will be different, I doubt it will be all that much so. After all, last I saw the ‘30s and the ‘70s both had some pretty miserable markets, and the 4% rule would have worked then. Are things going to be all that much different? I say no, but I don’t know this. I am not a prophet.

Gary Silverman, CFP® is the founder of Personal Money Planning, LLC, a Wichita Falls retirement planning and investment management firm and author of Real World Investing