Why the famous 4% withdrawal rule for retirement may not be the answer

SIMPLE ideas to address a complicated problem tend to have staying power. For decades, the 4 per cent rule has served as the anchor point for retirement planning, promising an easy and elegant solution to one of life’s most perplexing retirement puzzles: How much is enough?

The rule says a retiree can safely withdraw 4 per cent of their initial retirement portfolio, adjusted annually for inflation, for 30 years. This offers a gift of certainty.

But certainty is often the enemy of truth. The 4 per cent rule is not a timeless law of physics; it is predicated on a specific and exceptional time in American financial history. Relying on it today ignores the reality of the vastly different investment dynamics across time, geographies and even longevity.

Origin of the 4 per cent rule

The 4 per cent rule owes its genesis to the work of financial planner William Bengen in 1994. His breakthrough was not rooted in probabilistic modelling. Instead, he was looking for the absolute worst-case scenario in financial history that a retiree could have survived based on a balanced portfolio.

He found this in a retiree who began his decumulation journey in October 1968 and faced a crippling double blow: a devastating bear market immediately followed by a prolonged period of inflation. This combination substantially eroded the portfolio’s value while ratcheting up annual withdrawals to keep up with surging inflation. The 4 per cent rule was conservative enough to sustain the retiree – even through that catastrophic starting environment – without going broke for a 30-year retirement period.

But the rigidity of the rule is its inherent flaw. It mandates that retirees increase their spending based on inflation, irrespective of how the portfolio has performed.

Imagine a farmer committed to harvesting the same fixed amount of grain every year, regardless of whether they faced drought or insect infestation. If the harvest shrinks, the farmer is forced to sell their seed corn just to survive the current season, ensuring failure in the next.

The 4 per cent rule forces investors into this same dangerous corner, dictating action based on inflation, not on the portfolio’s current capacity to compound.

Flaw in the foundation: an American anomaly

The simplicity of the 4 per cent calculation hides a deeper problem. It was built on decades of uniquely favourable, high real returns from US markets. The financial climate that birthed the rule simply does not exist elsewhere.

The pioneers of the safe-withdrawal rate relied on historical rolling periods when real bond returns averaged 2.6 per cent. Bonds were a reliable shock absorber. Today, many developed economies have experienced periods of near-zero or negative real yields. The safety margin vanishes in such an environment.

For investors outside the US, the 4 per cent safe-withdrawal rule turns out to be lower. International studies by Dr Wade Pfau demonstrated that while the US enjoyed low volatility and high real returns, other countries were not so lucky. If one had retired in Japan in the 1940s, their theoretically “safest” withdrawal rate could have been as low as 0.47 per cent. What worked for the US was idiosyncratic, not a universal law.

Retirement killer: sequence-of-returns risk

The fatal geometric flaw of the 4 per cent rule is its inability to manage the sequence-of-returns risk (Sorr). Sorr is not about the average return you earn over 30 years, but the order in which you earn them.

When a retiree hits a sharp market downturn in the first decade, they suffer a double whammy. The portfolio value shrinks, and they are simultaneously forced to sell more assets at rock-bottom prices to meet their fixed annual income need. The market may eventually recover, but because the retiree was forced to liquidate a larger portion of their principal, there is not enough left to compound and benefit from the recovery.

This vulnerability is concentrated almost entirely in the first years of retirement. Retirement planning, therefore, is not about planning for three decades, but about ensuring that the first decade does not deliver a catastrophic blow to the retirement journey.

The best way to defeat Sorr is to replace rigidity with flexibility, aligning one’s consumption with their portfolio’s current health.

The fixed 4 per cent rate is arguably overly conservative because it was chosen to survive the single worst outlier in history. Dynamic rules free the retiree from the burden of planning for the absolute worst scenario, while allowing for greater lifetime spending with a low risk of ruin.

Potential mitigants

First, introducing some spending flexibility instead of a fixed one will help to sustain portfolio resilience over the planning horizon.

The retiree sets an initial spending rate, but establishes a lower spending rate if portfolio returns fall below a certain threshold. For example, instead of spending 5 per cent, the retiree can set a rule that if the preceding year’s returns is negative, spending rate will downshift to 3 per cent, for instance.

Second, asset allocation is probably the most crucial structural defence. As one retires, unless wealth is significant relative to the spending rate, it is prudent to avoid excessive volatility. Sorr risk is the highest when the portfolio is susceptible to large drawdowns.

Managing volatility does not mean holding a large amount of cash, but gaining exposure to multiple asset classes in a diversified manner. Introducing more asset classes can also raise returns without a proportionate increase in risk.

Another strategy is to consider an increasing equity glidepath. Instead of a fixed allocation over time, one can start retirement with a lower equity exposure and gradually increase it over the next decade. If the market drops, income from the stable fixed-income portion can be drawn down, giving time for the growth-oriented equities to recover, thus eliminating the negative compounding damage of Sorr.

This may sound counter-intuitive, but Sorr is high when the horizon is long. Once the critical first decade has passed, you increase the stock exposure to provide the necessary long-term growth to combat inflation for the remaining years.

The 4 per cent rule was a necessary starting point in the development of retirement planning. But the modern economy is too dynamic to be governed by a single fixed number derived from one country’s unique historical bull run.

Economist William Sharpe once called retirement’s drawdown phase the “nastiest, hardest problem in finance” because of the immense number of uncertainties and variables involved, including unknown longevity, fluctuating investment returns, changing inflation rates and fluctuating spending needs.

The key to navigating this is to understand the dynamics and to craft a sensible retirement strategy that involves flexibility and resilience.

The writer is chief investment officer, UOB Private Bank