3572: The 4% Retirement Rule: Why You Can Plan but Not Predict by Chris Reining on Limits Of The 4% Rule

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[00:00:47] This is Optimal Finance Daily. The 4% Retirement Rule. Why You Can Plan But Not Predict by Chris Reining of chrisreining.com Apollo 13 was going to be the third time Americans had landed on the moon. But there they were, 205,000 miles from Earth, when they heard a loud bang.

[00:01:13] I knew right away it was not a normal circumstance, said one astronaut. An oxygen tank had exploded, crippling the spacecraft. Operating on limited power, the crew had little heat or water and were forced to rig the carbon dioxide removal system in order to survive.

[00:01:32] After a nail-biting six days, the crew safely returned to Earth. In the investigation that followed, the cause of the failure was determined to be an unlikely chain of events.

[00:01:43] High temperatures inside the oxygen tank had melted wire insulation, causing them to short-circuit and produce sparks igniting more insulation, which then boiled the liquid oxygen inside the tank, which caused the internal pressure to exceed its limit and blow the bolts right off the tank. Arguably the most sophisticated space program in the world, yet defeated by some wire insulation. You can plan but not predict.

[00:02:13] And if you're planning for retirement, it won't take long before you come across the 4% safe withdrawal rate, which goes something like this. Withdraw 4% of your investment portfolio the first year of retirement, and then take that same dollar amount every year adjusted for inflation. One of the first questions people ask about the rule is, What happens when there's a recession and the market drops 30 or 50%? What then? They're asking about sequence of return risk.

[00:02:43] For example, if you retired with a million, then withdrew your first 40,000, a million times 4%, and then a recession followed. Let's pretend your portfolio dropped to 800,000 based on poor returns. And so in a year or two, you're forced to take a withdrawal of 40,000 plus inflation, but you're taking it at the worst possible time. In fact, you quickly calculate that you're not withdrawing 4%. It's closer to 5%.

[00:03:10] Don't worry, because that's not how you apply the 4% rule. Here's how the 4% rule works. Year 1, withdraw 4%. Year 2, forget you've ever heard of the 4% rule and withdraw 40,000 multiplied by the prior year's inflation rate. If inflation was 2%, you withdraw $40,800. In year 3, withdraw $40,800 multiplied by the prior year's inflation rate, and so on.

[00:03:40] So the 4% rule only matters for the initial withdrawal, and then it doesn't matter anymore. The reason why the 4% rule works during recessions is because the 4% rule is based on the worst possible historical scenarios. That's the whole point. Withdrawing that initial 4% incorporates someone who retires on the cusp of some financial nightmare. The depression, dot-com bubble, recent recession.

[00:04:07] In fact, Bill Benjen, who originally developed the 4% rule, is now saying his research shows the rule for a 30-year retirement period has ticked up to 4.5%. He goes on to say, quote, As your time horizon increases beyond 30 years, as you might expect, the safe withdrawal rate decreases. For example, for 35 years, I calculated 4.3%. For 40 years, 4.2%.

[00:04:35] And for 45 years, 4.1%. If you plan to live forever, 4% should do it, end quote. In other words, the withdrawal rules work because that's how the rules are designed. In fact, the vast majority of people won't face sequence of returns risk. They'll enjoy decent market returns early in retirement. Their investments will compound. This is why Michael Kitches makes the case that following the 4% rule is mostly unnecessary.

[00:05:04] His research shows that if you start retirement with a million and use a 4% initial withdrawal, you're more likely to have 5 million after 30 years than ever dip into principal. It's probably okay to use a higher initial withdrawal, but you use the rules because it's impossible to predict how the future unfolds. To highlight this fact, Benjen took two people who retired in 1968. One retired in April and the other in October, six months later.

[00:05:35] Using an initial 4.5% withdrawal, the October retirees portfolio lasted just 30 years, while the April retirees lasted 50. So the problem isn't that planning with these rules doesn't work. They've worked for nearly 50 years. The problem is you can't predict what will happen. At some point, you have to be okay with that. Dealing with the unexpected conditions that life throws at you. You adapt, just like the Apollo 13 astronauts.

[00:06:03] You just listened to the post titled, The 4% Retirement Rule, Why You Can Plan But Not Predict, by Chris Reining of chrisreining.com. Dell PCs with Intel inside are built for the moments that matter. For the moments you plan and the ones you don't. Built for the busy days that turn into all-night study sessions. The moment you're working from a cafe and realize every outlet's taken.

[00:06:33] The times you're deep in your flow and the absolute last thing you need is an auto-update throwing off your momentum. That's why Dell builds tech that adapts to the way you actually work. Built with long-lasting batteries so you're not scrambling for the closest outlet. And built-in intelligence that makes updates around your schedule, not in the middle of it. They don't build tech for tech's sake. They build it for you.

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[00:08:24] on sequence of return risks and withdrawal strategies, I highly recommend you check out the Risk Parity Radio podcast hosted by my friend Frank Vasquez. The show explores how to construct portfolios that are robust and can be drawn down on in perpetuity, and to maximize projected safe withdrawal rates regardless of projected overall returns. Frank argues that you cannot solve sequence of return risk with withdrawal techniques

[00:08:52] because it's a portfolio-level asset allocation problem. For example, trying to solve short-term sequence of return risk with lots of cash leads to lots of long-term failure risk. He also mentions that the danger is actually not a three-to-five-year tropical storm downturn early in retirement. It's a decade-long multiple-dip hurricane downturn such as experienced in the 1970s or 2000s.

[00:09:20] So those need to be the baselines to evaluate your portfolio against. What that ultimately means is that it's actually the diversification of your medium-to-long-term assets on five-to-seven-year timeframes that matters the most to solve this problem. Not just having a bunch of cash or CDs, etc. up front that really only takes care of the small flood problem. While guidelines like the 4% rule are very helpful, I appreciate how Frank points out

[00:09:48] that it's important to construct a diversified portfolio that historically survives worst-case conditions and then actually test said portfolio with historical data and Monte Carlo simulations. But that'll do it for the Monday episode. Have a great start to your week, and I'll be back tomorrow as usual where your optimal life awaits.