What Almost Everyone Gets Wrong About The Retirement Distribution 4% ‘Rule’

Let’s talk about the “4% rule,” originally from Bill Bengen’s seminal retirement distribution strategy research published in the Journal of Financial Planning in 1994. 

In his research, Bengen found that historically at that time, you could have taken 4%, adjusted for inflation each year from an investment portfolio of a 50/50 mix of large cap U.S. stocks and government bonds, and it would not have run out of money in a 30 year-retirement. 

So, to use an example, let’s say you started retirement with this investment mix and $1 million. Bengen’s research suggests you could support a $40,000 distribution per year, adjusted for inflation, for 30 years and not run out of money. This finding was eventually termed the “safe withdrawal” rate, because historically you could safely withdraw this rate from this type of portfolio and not run out of money. 

Along the way, though, some interesting things happened. First, this became one of the most popular pieces of retirement income research and finding. Second, many people started to misunderstand and misuse this finding. Instead, people started calling it a “rule.” I put “rule” in quotations because it’s not a rule – it’s a finding. Bengen did research in 1994 and found this was true in the past. 

Additionally, people started applying the 4% withdrawal rate to other portfolio mixes assuming they would also support 4% inflation-adjusted distributions for 30 years. But nothing about the research suggested that would be the case – it actually suggested otherwise. The sustainable distribution rate is very much determined by the investment mix and the timing of investment returns, i.e., the sequence of returns. 

For instance, I recently read an article about applying the 4% rule to a 100% TIPS portfolio and how this would now fail, as it wouldn’t last 30 years. There is nothing wrong with applying a 4% distribution strategy to a portfolio, but that wasn’t Bengen’s finding. His finding was specifically about a specific portfolio and only looking backward at historical returns. The finding was looking at a particular asset allocation, not whether you could take 4% distribution of any asset mix and make it last for 30 years. 

Most people likely don’t retire with exactly a 50/50 government bond and large cap stock portfolio. In fact, you can likely improve the performance and sustainability with a more diversified investment mix. 

Past Performance Does Not Equal Future Performance 

Another thing often lost on the 4% “safe withdrawal rate” finding is that countless researchers and projections have sought to determine the correct number today! Instead of looking backward, as Bengen did, people try to project forward by adding today’s interest rates and market assumptions into a similar model to see the likelihood of the 4% strategy working under current market assumptions. Morningstar had a great piece on this earlier this year, and Wade Pfau and David Blanchett have conducted research on this as well. 

All these researchers and articles have one common finding: 4% might not work going forward. Well, duh! The research never implied this will always work going forward. While it’s good that research is being conducted on sustainable withdrawal rates and is constantly being improved upon, the 4% finding was never the “safe” number. 

Why? Past performance does not guarantee future performance. We already know that. It was never “safe” or a rule. Instead, it was a good measure of what happened in the past – a guideline and a finding to help us when looking at retirement distributions strategies moving forward. We cannot know what the truly “safe” withdrawal rate over the next 30 years is. It could be 4%, it could be 5%, it could be 2%. We can make some educated guesses, but it remains an unknown until we see what happens. 

What the 4% Distribution Finding Really Teaches Us 

Bengen’s research is still good research, and the 4% safe withdrawal rate literature is some of my favorite in all of retirement income planning. It’s still a good measurement and guide for us, but thinking of it as safe for all future years, or as a rule, is the wrong way to look at it. We do need benchmarks, and it’s helpful to understand what happened in the past, but we cannot look at this as if it’s some infallible strategy that works in all cases and with all portfolios. 

Additionally, what this research really did was shine a light on sequence of returns risk. You might be able to average 6%, 7% or 8% in retirement as a total return over 30 years, but your average return does not solely determine what you can spend. In fact, you can average 8% return but still only be able to spend 4% for a 30-year retirement if you get large negative investment experiences early in retirement. The sequencing of your returns matters once you start to pull money out of an investment portfolio. 

So, what is that “rule” today? Is it 2%, 3.2%, 4%, 5% or 6%? It actually really doesn’t matter. What matters is that we are learning the importance of sequence of returns, that we need a retirement income plan in place and that markets and strategies will continue to evolve, so we need to create flexibility in spending in our retirement income plan. 

Retirement income planning is not driven by “rules” – instead, I describe it as like trying to hit a moving target in the wind. Your target is your personal goals and that target is moving because we don’t know how long we’ll be in retirement (not everyone has 30-year retirements), and the wind is those things that will change your course along the way.