Ep 67: Is The 4% Rule Still Viable? with David McKnight

February 12, 2020
The 4% Rule originated with a man named William Bengen in 1994. He looked back and noticed that people were withdrawing from their portfolios at a very haphazard rate. Prior to 2005, a common way people used to determine how much they could withdraw was to look at the average return of the market at...

Episode Transcript - Is The 4% Rule Still Viable? with David McKnight

A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
Hello there. David McKnight. Welcome to The Power of Zero show. I’m grateful that you're carving out a little bit of time out of your schedule today to check in with us and learn more about The Power of Zero Paradigm. I am the best-selling author of The Power of Zero, Look Before You LIRP, and The Volatility Shield, as well as a new book that will be coming out. We actually have a launch date, February 9th, 2021. Remember, the big five publishers, particularly, Penguin Random House like to take their time with this type of stuff. They are very methodical, very thorough, so we can start looking forward to that. It's a little over a year away. I’m about 70% done with the manuscript, actually, but you can trust that it will be refined, edited, and it'll be just perfect when it comes out in February. I’m looking forward to sharing that with you and discussing some of the topics that will be discussed in that book over the course of the next year.
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The topic of today's discussion is this, “Is the 4% rule still valid in today’s economic environment?” Before we get into that, let's discuss a little bit of background as it relates to the 4% rule. What is it, how did it come about, so on and so forth. Back in the day, there was a guy named William Bengen, who, in 1994, looked back over the arc of investment history and he said, “Look, people are withdrawing money from their retirement portfolios in a willy-nilly haphazard way.” In fact, back in the day, the way they figured out what sustainable distribution rates were from your retirement portfolios was they would look at whatever the going rate in the market was, let's say the S&P 500 over the previous 30 years had done 7%, they'd say, “Oh, 7% then is the sustainable rate that you can withdraw from your portfolio.”
Now, you may be thinking that that's a long time ago, that's outdated thinking. As recently as 2005, you'll find this in Tom Hegna’s book, Paychecks and Playchecks, MetLife did a study where they asked retirees what they thought was a sustainable distribution rate from their retirement assets. In other words, what percentage of their total retirement portfolio, starting day one of retirement, could they withdraw, keep up with inflation, and never run out of money before they die? Like 40% of the people said 10%.
You'd like to think that we learned from our errors and that history has been a good teacher to us, but that simply has not been the case. More or less Americans are not real educated on what sustainable withdrawal rates are. William Bengen was disturbed about this. In 1994, he started to do what later became known as Monte Carlo simulations where he got his computer, he went backwards in time 70 years, and he said, “Let's take the rates of return we got in the S&P 500 over the last 70 years and let's scramble them in every possible different combination.”
He didn't do 100 combinations, he didn't do 1,000 combinations, he did 100,000 combinations. He also varied the length of retirement, he varied the weight of withdrawal, and he also varied the stock/bond mix. What he discovered was that the current rates of distribution back then, which was 7%, were entirely unsustainable. What he realized was that the only way to give yourself a high probability of getting your money to last through life expectancy was to take out 4%.
His computer modeling demonstrated that 4% was a sustainable rate. In other words, if you have $1 million starting day one of retirement and you want to keep up with inflation over time, the most you could ever take out is 4% or $40,000 and then adjust that $40,000 for inflation over time. Over a 30-year retirement, there was something like a 90% likelihood that your money would last until the end of that 30-year period.
This became the way to combat what we call longevity risk. What is longevity risk? Longevity risk is the risk that you will run out of money before you run out of life so that you will go broke at some point in time before you actually die. This is, by the way, the number one concern for retirees, running out of money before they die. With this William Bengen solution, this 4% rule became the gold standard for the industry. As long as by day one of retirement, you only took 4% of your retirement portfolio and adjusted that for inflation, so $40,000 adjusted for inflation, call it 3% per year over time, then that would give you, not 100% probability that your money would last until death, but a high probability that your money would last through that 30-year time period.
Of course, if you wanted your money to last 40 years, you could still take out 4%. You just didn't have as high a likelihood of the money lasting as long. There are all sorts of different things that you can do to fiddle with the formula and those things that you can do to fiddle with the formula will either increase the probability that your money will last longer or it will decrease the probability that your money will last longer.
Before I get into my issues with the 4% rule, let's talk about whether the 4% rule is still valid today. Now, when William Bengen, this is back in the early 90s, when he formulated his 4% rule, I remember, he was using a stock/bond mix of 60/40. You have 60% of your portfolio in stocks, 40% in bonds. Back then, bonds were cranking out at about 6.6%. Bonds were doing extremely well and that was the rate of return that he used in that 40% of the bond portfolio.
Here's the problem, in today's post-recession world, while stocks are doing great, bonds are not doing as well. Bonds are only at 2.2% in today's environment. Everybody across the board, whether it's Vanguard, economists, or retirement experts, they're all revising the 4% rule downward. They're saying that if you still want to have a high likelihood of having your money last through life expectancy, in other words, successfully combat, successfully neutralize longevity risk from your retirement portfolio, you can no longer take out 4%. If you take out 4%, the probability that your money lasts until you die drops dramatically. That's primarily a function of where bond returns are these days.
What they've done is they've revised that 4% rule downward and they say that now, the 4% rule is only the 3% rule. If you got $1 million, you can take out 3% or $30,000 per year, couple that with inflation, say 3% per year, and take that amount, couple it with your Social Security, and that should be able to meet your lifestyle needs through life expectancy. This is a problem. The reason it's a problem is because trying to combat longevity risk, trying to mitigate longevity risk is an expensive proposition even if you use the 4% rule. Think about it, let's say you need $100,000 per year to live above and beyond what you're getting from Social Security, you need $100,000 to live in retirement above and beyond what you're getting from Social Security, based on the 4% rule, how do you figure out how much money you'll need to be able to have your money last through life expectancy?
What you do is you take that 4% and you divide it into $100,000. You divide 0.04 into $100,000 and what you find is that you will need $2.5 million. A pretty expensive proposition, $2.5 million on day one of retirement. As I discussed in my book, The Volatility Shield, if you're not on track to hit that amount, you can resort to five heartburn-inducing alternatives that can help you get to that amount by the time you retire. You can save more, spend less, work longer, die sooner, or take more risk in the stock market. Those are the five things that you can do to pump up your portfolio so you'll have the $2.5 million by the time you retire.
Here's the problem with revising the 4% rule down to the 3% rule, when you revise it down to the 3% rule, you now have to divide 0.03 into the $100,000 number. When you divide 0.03 into $100,000, you now find that you no longer have to have $2.5 million, you have to have $3.33333 million or $3,333,333.33. That's how much you would have to have day one of retirement to be able to last that full 30 years of retirement.
What was before a very expensive cash-intensive, high-asset proposition is now even more expensive. If you're going to use the stock market and the 3% rule to guarantee that you'll have enough money through life expectancy, it's becoming an even more expensive proposition. That's, I think, my number one hang-up with the now 3% rule is it's very expensive, it takes a lot of capital to be able to have a high probability of reaching life expectancy without running out of money. Even then, it's not 100% guaranteed because what if instead of 30 years, you live 40 years? All of a sudden, the numbers change dramatically. That's my first issue, it's very expensive.
My second issue with the 4% rule is that you have to be willing to show allegiance to the 4% rule even in very erratic markets, in other words, what do most investors do that don't have good advisors? You're supposed to buy low sell high, what do they do? They buy high and they sell low. Why? Because they succumb to emotion-driven investing. For example, I think of lots of clients back in 2008 when the market took a tumble, it was down 38%, people were bailing out, they're saying, “I don't want to lose all my capital.” They got out at the bottom and then they failed to get back in until it started to go back up again. They did exactly the wrong thing, the exact opposite of what you do.
Guess what, in order for the 3% rule to work for you, you have to keep your money invested in good markets and bad. If you're constantly moving the cash when you think things are going badly and then you move money back into the market when you think things are going up, it is impossible to time the market. You will throw the 3% rule off by acting erratically when markets go up and down. You have to be able to be disciplined and conform to the 3% rule regardless of what markets are doing. You gotta ask yourself, do you have the ability over retirement, regardless of what markets are doing, to only take out 3% and leave money in the market the whole time? That's the second hang-up I have. I don't think that a lot of people have the ability to pull that off.
The third issue is what I call the illusion of liquidity. The illusion of liquidity basically says that let's say you got that $3.3333 million sitting in your IRA—and that's plenty of money to be able to sustain that $100,000 lifestyle in retirement, when coupled with your Social Security, increased for inflation over time—here's the issue, if you have $3.333 million, on paper, it looks like you're flush with cash, it looks like you've got all this money that you can earmark for all sorts of different things, a shock expense, what I like to refer to as an aspirational retirement goal, this could be taking a trip around the world, it could be flying all the grandkids into Disneyland, it could be buying a new car, fixing a roof, there are all sorts of expenses that crop up in retirement above and beyond your basic lifestyle expenses. Here's the problem if you have $3.333 million, it's easy to look at that money that's sitting on your kitchen counter in the cookie jar as it were, very accessible, it's very easy to be seduced by that and say, “Man, I've got all this money. I can spend it on whatever I want because it's a huge massive amount of money.”
The problem with that mentality, of course, is that every single bit of that $3.333 million is earmarked for the 3% rule. It's all earmarked for that $100,000 lifestyle. In the very moment that you take out more than $100,000, then you violated the 3% rule and the probability that your money lasts through life expectancy starts to drop like a rock. You're looking at this bucket of money and saying, “I'm liquid, I'm flush with cash,” the reality is it's not liquid because if your plan is to live by the 3% rule, all of that money is earmarked for the 3% rule. If you want to have a completely separate buffer fund that goes to pay for things like aspirational goals, shock expenses, healthcare expenses, fixing the roof, what have you, lending money to a family member, then you would have to have an amount of money sufficient to meet all of those goals above and beyond the $3.333 million.
We’ll address what I believe are some better solutions to solving longevity risk in subsequent podcasts, but we have to be clear on what the shortcomings are of the 4% rule, and now the 3% rule, because it's something that is conventionally an approach that people take to mitigating longevity risk. They say, “As long as I'm only taking out the 4% or the 3%, my money will adjust for inflation and it will last through life expectancy.” The fact is that works in a vacuum but very few of us live in a vacuum in retirement.
That's the podcast for today. We're going to be tackling a lot of issues similar to this for retirees over the course of the next year between now and when my book launches February 9th, 2021, excited for you to learn about all of the different things we'll be discussing in that book. Once again, if you’re an advisor and want to learn how to incorporate this stuff into your practice, go over to and opt in to our video series. If you're looking for a Power of Zero advisor, go over to, put your information into the intake form, and we will hook you up with a highly qualified, certified Power of Zero advisor that can help you navigate all of the pitfalls that stand between you and the 0% tax bracket.
If you can put some reviews of our books on Amazon, that increases the credibility and legitimacy of our books. The more reviews that are there, the better off. When people get our books, they go to Amazon and they look to see what the review says and how many of them there are. The more reviews we have on there, the better off everybody is because as people look at these books and they're trying to insulate themselves from tax rate risk and longevity risk, the reviews on Amazon are very, very helpful and it lends a lot of legitimacy to everything we're doing.
Also, you can follow me on Twitter at @mcknightandco. I would love a follow on Twitter. Again, subscribe. If you subscribe to our podcast, you'll get an email with the topic and the link to our podcast every single week in whatever channel you listen to podcasts. Thanks, everybody for being on the show today and excited to talk to you next week. Talk to you soon.

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