Is the '4% Rule' Broken?

Note: This article is part of Morningstar.com's 2020 special report, "Are You Able to Retire?" A version of this article originally published in July 2020.

Retirement researchers have been sounding the alarm about the 4% guideline for a while. They've noted that the combination of very low bond yields and not-inexpensive equity valuations mean that a starting withdrawal of 4%, with that dollar amount adjusted for inflation in each year thereafter, could cause a retiree to prematurely deplete his or her funds over a 25- to 30-year horizon. The fact that the current pandemic has forced yields lower still--to just 0.62% on the 10-year Treasury as of July 9, 2020--imperils the 4% guideline even further.

In an interview on The Long View podcast, recorded in March 2020, retirement researcher Wade Pfau discussed the case against the 4% guideline. He also shared some thoughts on withdrawal strategies that retirees should consider instead. Pfau is a professor of retirement income at The American College of Financial Services. This excerpt from the interview has been lightly edited; the entire transcript covers other aspects of retirement planning, including long-term care and what Pfau calls "buffer assets."

Christine Benz: Wade, you mentioned withdrawal rates, which are an important component of retirement planning. The obvious adjustment to make in the face of a declining market would be to reduce withdrawal rates. In fact, you wrote this week that it's important to understand that the 4% rule does not apply today. Basically, you made a very clear statement. Why is the 4% rule broken in today's environment?

Pfau: Well, there are a number of factors--people are living longer, and the 4% rule ignores taxes, it assumes investors are not paying any fees on their investments, and so forth. But the biggest driver for what I'm talking about right now is the low-interest-rate environment. Low bond yields mean low bond returns in the future. And there's not really any controversy about that. It's a very close mathematical relationship. If interest rates don't change, today's bond yields will be the bond returns. And then, of course, if you're holding bond mutual funds, well, if interest rates go up, you're going to have capital losses, which make things even worse. Or vice versa, if interest rates decrease further, you could have capital gains. But effectively, future bond returns are going to be very close to today's bond yields. And that means spending from bonds is going to be lower mathematically. And for the 4% rule, it's just based on U.S. historical data, where we've never seen interest rates this low. The one time we saw the 10-year Treasury yield fall below 2% was just very briefly in the early 1940s.

So, if you are just trying to fund retirement with bonds and starting in the early 1940s, you'd be looking at about a 2.5% withdrawal rate for a bond portfolio. But for a diversified portfolio, stocks came to the rescue of bonds in the early 1940s. Because this was now after the Great Depression, and stocks were undervalued. Going back to [Robert] Shiller's analysis--stocks were undervalued in the early 1940s. And so, the long-term prospects for stocks were much better at that point. And they did come to the rescue. And for a diversified portfolio, the 4% rule survived in the early 1940s, when it's the only time we saw interest rates low like today.

But today, we're dealing with this high-valuation environment and historically low interest rates, lower than the 4% rule ever had to be tested by. And so, it's not as clear how stocks can come to the rescue of bonds. So, you're really starting from a position where the 4% rule is under a lot more strain. And it's really sensitive to market returns. Like, if you just take historical average data and plug that into some sort of financial-planning calculator, which is kind of the naive approach that still gets used today, that will be assuming you're going to have 5% to 6% bond returns in the future. The 4% rule looks like it's going to work 95% of the time. But if you just lower returns to account for lower interest rates, and because of this idea of sequence-of-returns risk, even if interest rates normalize later to their historical averages, that's kind of too late if you're retiring today. Based on those kinds of projections, you're going to be looking at the 4% rule working more like 60% to 70% of the time. And that's usually not the amount of safety people want. If you want the kind of safety of at least getting your strategy to work 90% of the time, the lower interest rates are going to push you toward something like 3% being a lot more realistic than 4% as a sustainable strategy in a low-interest-rate environment.

Benz: You mentioned variable spending, Wade, as a way of potentially addressing these conditions. So, a very crude way to do that would be to simply use a fixed-percentage withdrawal and take the same percentage out of a portfolio every year regardless of what the portfolio value is. But that's obviously not ideal from a quality-of-life standpoint. So, let's walk through how one could create a sensible variable withdrawal strategy.

Pfau: What you explained would be the opposite end of a spectrum of extremes. The 4% rule is one extreme. Well, it's 4% of your initial retirement assets, which tells you how much you can spend. And then you just keep spending that same amount every year and you never adjust based on market performance. There's always going to be a withdrawal rate, but you don't care what it is, you just keep spending the same amount.

Then what you described is the opposite end of the spectrum, which is, you just spend a fixed percent of what's left every year. So, you're always using the same withdrawal rate every year, but your spending will fluctuate, and it could fluctuate quite dramatically just based on how your portfolio is doing. Those are the two ends of the spectrum.

And then, there's a whole host of strategies in between that try to develop some sort of compromise between thinking you should make some adjustments to your spending. And that does help manage sequence risk. But you don't necessarily want to adjust your spending too much. In practical terms, just following the required minimum distribution rules to define spending in retirement, that's going to be related to the fixed-percentage strategy, but it actually is pretty closely aligned with what academic research shows is the optimal way to spend beyond that as well. So, different advisors have proposed different types of variable spending strategies.

One of my favorites is actually from Bill Bengen--and he's the one who created the 4% rule initially. But he talked about a "floor and ceiling" approach, where you spend a fixed percentage of what's left every year, but you decide you're going to have a floor that you don't want your spending to fall below a certain dollar amount, and then you have a ceiling where you're not going to let your spending go above a certain dollar amount. So, as long as you're within that range, you just spend a fixed percent, but you apply the floor and the ceiling. And this helps to manage sequence risk by adjusting your spending. That floor might not be all that much less than what the 4%-rule logic--always spend the same amount every year no matter what--would have had you spending. So, you have the potential to spend more on average, and even on the downside, you're not really spending all that much less. That can work very well to help manage the sequence risk. That's a pretty easy strategy to implement. And I think it has a lot going for it. It's one of my favorites.

There's a lot of other strategies out there as well. Jonathan Guyton developed his decision rules with William Klinger that are a lot harder to implement in practice and do call for occasional 10% cuts to the distribution that are permanent. But that could be another option as well.

Benz: That's a good summary. Before we leave required minimum distributions as maybe a benchmark that someone could use, just talk about the virtues of that. It updates with my age and my portfolio value, and so that is valuable?

Pfau: The academically optimal way to spend is, you're going to adjust your spending every year to reflect your portfolio value and your remaining longevity. As people age, their remaining life expectancy gets shorter. And so, naturally, people can spend a higher percentage of what's left as they age. The required minimum distribution rules guide that sort of spending. Now, they are conservative, because they're based on assuming a 0% return for the asset base. And they're also based on a couple where one spouse is 10 years younger than the other spouse. So, you could play around with making them a little more aggressive if you want to spend a bit more aggressively. But generally speaking, that's what academics are saying: spend an increasing percentage of what's left every year as you age. And that can be the most efficient way to spend down your assets in retirement. That's where they get attention as an easy way to implement a more efficient and optimal type of way to spend down assets in retirement.