4% Rule Revisited – I Want A Raise!

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Recently I wrote about the 4% withdrawal rule which is a guide for safe portfolio withdrawals in retirement. To reiterate, the basic rule is that you withdraw 4% of the portfolio in the first year of retirement and then every year afterwards you withdraw the amount you took out the previous year plus inflation.

Bill Bengen who was the “creator” of the 4% rule no longer uses it in his financial advisory practice. The problem with the 4% rule (actually the 4.2%) rule is that while it does accomplish the goal of ensuring that an investor who follows the rule will not likely outlive their money – if the portfolio performance is better than expected, then the calculated withdrawals will be too conservative and might end up almost guaranteeing that the investor dies (at an old age) with a large amount of money remaining which might not be what was intended.

Bengen’s new strategy is as follows:

Flexibility is factored into Bengen’s revised approach, which permits withdrawals to fluctuate within guidelines. His “floor-and-ceiling strategy” suggests that an initial withdrawal rate of 5.16% would be appropriate if a retiree pares back subsequent withdrawals by as much as 10% of the initial withdrawal during hard times (the floor). On the other hand, a retiree could withdraw extra cash equaling up to 25% of the first-year withdrawal (the ceiling) when the market is strong. The starting rate would vary depending on how much volatility a retiree could stomach. (More details on his research are at billbengen.com.)

He does add that there is no “absolute solution” and that “In general, I think you are better off planning conservatively initially because you can always make adjustments later.”

William J. Bernstein who is a big fan of the 4% rule, also talks about withdrawing a fixed percentage of the portfolio each year instead of a fixed amount based on the first year withdrawal plus inflation. This is the ultimate in flexible withdrawals but the problem as he notes is that the withdrawal amounts can vary by a large amount each year due to market fluctuations. As Bernstein aptly puts it “Keep a few cans of Alpo in the cupboard if you decide to go this route.”

I’ve always been a fan of being flexible with withdrawal rates so I like the idea that maybe the rigid 4% rule is a bit too rigid. I’m thinking of having a retirement plan where I start with a withdrawal rate of 5% and be flexible depending on the markets. One way to be able to do this is to have a fair bit of “extra” money built into your retirement scenario. For example if you are planning to retire with $50k per year (in today’s dollars) but $15k of that is for traveling and “extra spending” then if the markets tank, you could potentially cut your withdrawals down to $35k and maintain your basic standard of living. On the flip side, if the markets have a sustained rally in the beginning of your retirement then you can probably spend a bit extra. I think the key to handle that situation is to spend the bonus money on one time only costs such as vacations, renos, gifts etc. If you start buying more expensive houses or cars then those items will leave you with higher costs for a long time.