What’s wrong with The 4% Rule?

Some years ago, Bill Bengen, one of the Gods of Retirement Planning stumbled across the “4% rule”. Bengen never intended for it to be a “rule” but these simple rules of thumb tend to take on a life of their own.

Just in case you didn’t know, Bengen worked out that, if you had started off by withdrawing 4% per year from an investment portfolio made up of 50% of shares and 50% of fixed interest stock, and you increased that withdrawal by inflation every year, there would never have been a 30 year period when the original portfolio value would have been exhausted. As most people’s retirements last for less than 30 years, the 4% rule has been adopted as a rule of thumb as to what you can withdraw from your retirement savings.

Bengen subsequently changed him mind, raising his 4% rule to 4.7%. However, recent research has suggested that he is way too optimistic, and it should actually be reduced, to 3.3%. So, when there is such a difference, we have to start to ask which percentage rate is correct.

But there are other, much bigger flaws in the research. Firstly, Bengen’s “rule” assumes that there are no charges being deducted from the retirement portfolio. Research has shown that about 50% of the annual charges need to be deducted from the withdrawal percentage used – so, if the portfolio charges are 2% per year (pretty typical for the UK), then the 4% withdrawal rate should be reduced to 3%.

Perhaps for British investors, the biggest flaw is that Bengen only used US data. His figures are based on the returns from US shares and fixed interest stock, and US inflation.  As I’ve said before, using Bengen’s rule in the UK is similar to driving a gas guzzler up the wrong side of the M23, and hoping that everything will be ok.

The US has had some of the best returns possible, compared to other countries, and its inflation figures have been fairly benign too. Some countries, like Germany, have faced hyperinflation in the last hundred years, whilst, in other countries, like Russia, investors had their assets confiscated! The international, historical picture suggests that it’s best to live in a country that doesn’t lose World Wars, if you want to take high withdrawals from your retirement portfolio!

The UK has fared relatively well – we have had periods of high inflation, and investment returns here haven’t been as good as in the USA, historically. So, our equivalent of the 4% rule (ignoring charges) is still around 3.75%.

Added to that, recent improvements in medical science and potential further improvements mean that the assumption of a 30 year retirement isn’t particularly optimistic – there is a good chance that if a couple retires when the older partner is 60, one member of that couple might still be around on the older partner’s 90th birthday.

The 4% rule also assumes that you would invest 50% in shares and 50% in fixed interest stock. That would be an unusual portfolio for a retiree to have and maintain throughout their retirement. Other assets, such as cash and property, form part of most people’s portfolios.

The recent research, which suggested a starting withdrawal rate of 3.3%, was based on the assumption that returns from the fixed interest part of the portfolio would be lower in the future than they have been historically. Fixed interest returns tend to be poor when interest rates are rising, and with rates at their lowest levels historically, it is unlikely (but not impossible) that rates will continue to fall. So, it does seem reasonable to reduce withdrawals to take account of this.

The “4% rule” has so many flaws in it that it would be dangerous for a UK based investor to adopt it.

Thankfully, there is an alternative approach which can be used, as a result of the availability of data and our ability to use that data effectively. Our stress testing system allows us to look at how sustainable your proposed withdrawals would be over your expected retirement, taking account of your age, your own views on life expectancy and your views on investment risk. It can check out how you would have fared for every potential retirement period, starting from 1915 – telling us the chances that you would have run out of money during your lifetime. This provides with a much more accurate picture of how likely it will be that your retirement strategy will succeed.

If you would like us to stress test your retirement plan, please get in touch.

Philip Wise | philip@sussexretirement.co.uk

Managing Director and Chartered Financial Planner


This guide is for information purposes and does not constitute financial advice, which should be based on your individual circumstances.
A pension is a long-term investment, the value of your investment and the income from it may go down as well as up. Your eventual income may depend upon the size of the fund at retirement, future interest rates and tax legislation.
Past performance is not a reliable indicator of future performance
Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.

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