Time to Replace the 4% Rule

Retirement-Savings Withdrawal Strategy Is Flawed, but Replacement Is Complex

How much -- when the time comes -- should you withdraw from your accounts earmarked for retirement? Answer that question correctly and you get to enjoy the retirement of your dreams. Answer it incorrectly and you either outlive your assets or you leave more money to your heirs than planned.

Conventional wisdom suggests that you withdraw on average 4% adjusted for inflation. Now comes a paper co-authored by William Sharpe, the winner of the 1990 Nobel Prize in Economics, challenging the conventional wisdom.

"It is time to replace the 4% rule with approaches better grounded in fundamental economic analysis," wrote Sharpe in his paper "The 4% Rule -- At What Price?" (That paper appeared in The Journal of Investment Management in 2009, but resurfaced last week in the financial-adviser community and is sparking debate anew.)

"Supporting a constant spending plan using a volatile investment policy is fundamentally flawed. A retiree using a 4% rule faces spending shortfalls when risky investments underperform, may accumulate wasted surpluses when they outperform and, in any case, could likely purchase exactly the same spending distributions more cheaply."

Having a surplus is a problem. It means that you spent less than you could have in retirement, that you short-changed yourself. It means you could have spent more traveling to exotic places or visiting family and friends or splurging on your hobbies and philanthropic endeavors.

Having a shortfall is a much bigger problem, however. It means that you lived too large, too fast. And while it might not mean eating dog food late in life, it sure as heck could mean a much lower standard of life as you age.

According to Sharpe, who is also the founder of Financial Engines, the typical 4% rule recommends that a retiree annually spend a fixed, real amount equal to 4% of his initial wealth, and rebalance the remainder of his money in a 60%-40% mix of stocks and bonds throughout a 30-year retirement period.

What's more, he shows the price paid for funding what he calls "unspent surpluses and the overpayments made to purchase its spending policy." According to Sharpe, a typical rule allocates 10%-20% of a retiree's initial wealth to surpluses and an additional 2%-4% to overpayments.

By the way, the improvements to the strategy include changing the amount to withdraw based on market performance, or the length of the plan, or the portfolio mix, or the rebalancing frequency, or the confidence level.

Sharpe's study, in essence, shows that retirees waste money by adopting the 4% rule. "The 4% rule's approach to spending and investing wastes a significant portion of a retiree's savings and is thus prima facie inefficient," Sharpe wrote.

Instead, he suggests that retirees consider "maximizing their expected utility," an approach advocated by financial economists. "While we still may be far away from such an ideal, there appears to be no doubt that a better approach can be found than that offered by combinations of desired constant real spending and risky investment. Despite its ubiquity, it is time to replace the 4% rule with approaches better grounded in fundamental economic analysis."

These are points, said Boston University economics professor Zvi Bodie, "that have long been known to academics."

The only problem with what academia knows to be right and what's practical in the field -- even by Sharpe's own admission -- is this: "Many practical issues remain to be addressed before advisers can hope to create individualized retirement financial plans that maximize expected utility for investors with diverse circumstances, other sources of income, and preferences," Sharpe wrote in his paper.

Nothing Better Than 4% Rule

E. Tylor Claggett, a finance professor at the Perdue School of Business at Salisbury University, said the question of whether it's time to toss the 4% rule in the circular file is an old one and it has always been perplexing.

"The truth is, no one has a crystal ball," he said. "Therefore, no one knows how long the retiree will live, what his or her actual future financial needs will be (due to health issues and the like) and the future year-to-year performances of the various capital market components. If all of these were known, we would not have to have this discussion. Instead, we are left with looking for 'rules-of-thumb' to increase the probability that a retiree's needs will be met given his or her asset base at the time of retirement."

Others agree.

"It may be true that from an academic standpoint the 4% rule is less efficient than a more fine-tuned, more complicated approach that adjusts the withdrawal percentage based on time horizon and ongoing performance," said Rande Spiegelman, vice president of financial planning, Schwab Center for Investment Research. To Spiegelman, any rule of thumb, no matter how useful for long-term planning purposes, has limitations when applied to individual facts and circumstances.

So instead of slavishly following any approach, Spiegelman says it's always a good idea to remain flexible. "The 4% rule is easy to understand and follow, and provides a good starting point for the average investor looking for a ballpark idea of how much they need to save or, conversely, a ballpark estimate of how much they can safely withdraw," he said.

Meanwhile, Stephen P. Utkus, a principal with the Vanguard Center for Retirement Research, agrees that the 4% rule is flawed. But he also notes, as did Sharpe, that there's no practical mechanism to replace it with and that further research is required.

In the paper, Sharpe hinted at one strategy, which involves the purchase and sale of a complex set of options, but this, said Utkus, is "a technique that is not practical today and doesn't not exist in the real world of consumer finance."

Right now, Utkus said there's a big gap between academic theory and practice.

"Until academic methodologies come to a more practical set of solutions for households, they remain conceptual approaches, not strategies that can be implemented today with real-world clients and investors," said Utkus. "Over time, of course, the challenge is for academic models to become more real-world, and for real-world practitioners to learn from the academic models. Right now, there is a sizeable gap."

Meanwhile, academics are debating various models of what optimal draw-down methods should be, though by no means is there any settled consensus on the issue. What Sharpe's statement is saying is that, according to an economic model we have constructed, the 4% rule is flawed. Fair enough.

POWER - yes, it is good to have this is a guide for retirement planning.