Those of us who have been in the financial advisory business for years can sometimes take established rules of thumb for granted – so much so that the nuances of such guidelines may get lost.
Take the 4% rule. When I started talking more about this ubiquitous rule last year, I performed my own informal survey. Over the course of a month, I asked several financial advisers if they knew the rule. Most indicated that they were indeed familiar with this guideline. But when pressed, many of those money "pros" were unable to articulate the rule's details and intricacies.
Although it sounds as though it should be simple, in practice there are complexities of the 4% rule that can lead to confusion over time. Still, it is a rule that I believe all financial advisers should fully understand.
The 4% rule was originally developed by William Bengen, a financial planner from MIT. Mr. Bengen published his study in 1994 based on data through 1992 in the Journal of Financial Planning.
Through his research, Mr. Bengen found retirees can take 4% of their initial retirement assets and increase that amount every year to account for inflation, assuming a 50% to 75% portfolio allocation to stocks. In Mr. Bengen's study, applying the 4% rule led to a worst-case scenario of an investor's money lasting 35 years. Thus, the 4% rule was born.
Of course, there is debate over whether the 4% rule remains a useful and pragmatic tool. Last year, The Wall Street Journal published an article entitled "Forget the 4% Rule: Rethinking Common Retirement Beliefs." The piece touted the opinion of Wade Pfau, a professor at the American College of Financial Services, who believes, based on his research, that the 4% rule is obsolete and should be replaced with a more conservative 3% rule.
The article prompted me to research the state of the 4% rule. As a financial professional, I wanted to arrive at my own conclusion about the continued viability of this landmark rule.
I couldn't find research that extended beyond Mr. Bengen's groundbreaking study's original dates. So I took it upon myself to update the study's figures with an additional 25 years of data to bring it into the present day.
My team's work recreated the study with retirement withdrawals beginning every year from 1929 to 2009 — 82 separate retirement starting points. We used actual market data until 2017 and ran multiple simulations with historically conservative average return estimates thereafter: 5% for stocks, 2% for bonds and 3% for inflation.
What I found was that 70% of the time (58 of the 82 scenarios), retirement funds lasted 50 years or more. The remaining 30% of the time, the money "ran out," with the worst-case scenario in our study being 29 years.
So, my answer is yes, the 4% rule can still work.
I also added a few important pieces to my study that would hopefully assist other financial advisers in speaking to their clients about withdrawal rates.
We all know that hard-line rules and scolding don't work in the real world. I developed some guidelines around the rule to offer buffers, or safety zones, that give high-end (the danger zone at 6%) and low-end (the "Buffett" zone at 2%) parameters for ongoing conversations with clients.
The primary goal of this research and the accompanying safety zones is to help financial advisers understand the nuances of the 4% rule and be able to explain these intricacies to their clients cogently and pragmatically.
If, for instance, you sit down with a couple who are spending "too much," perhaps now you can simply remind them that the spending level isn't sustainable, and that they need to move into a middle- or low-safety zone of withdrawals soon.
Our bottom line is to ensure that our clients are in a safety zone within the 4% rule. Understanding the rule, its implications and the buffers I have identified are a great way to have that conversation.