The 4% budget: Why spending flexibility is more important than withdrawal rate in retirement

The recent market declines triggered by the COVID-19 pandemic raise important questions for those in or near retirement. When you add in historically low yields on fixed income investments and an uncertain economic future, questions arise about how retirees will weather the storm. Among other things, some may be questioning whether the 4% rule on investment withdrawals remains viable.

Since its first introduction in 1994 (see below), the 4% rule—which I prefer to think of as more of a guideline—has been the subject of both praise and debate. Its simplicity wins support from retirees, and its alignment with historical market return data wins support from many advisors and academics. Yet it’s also the subject of much debate, with many questioning its future applicability given today’s high equity valuations and low interest rates.

One aspect of the 4% rule that deserves more attention is what I call the “4% budget.” How a retiree spends the 4% is as important—perhaps more important—than whether 4% is the best withdrawal rate.

The 4% rule

The 4% rule is designed to help retirees calculate a safe withdrawal rate during retirement.

Following the rule, you can spend 4% of your nest egg during the first year of retirement. Thereafter, you adjust the amount of withdrawals by the rate of inflation each year. Following this simple plan, you can expect to have adequate funds throughout retirement. Or put more bluntly, the odds are you’ll die before you run out of money.

As simple as the rule is, there are some important nuances. William Bengen introduced the 4% rule in a 1994 paper published in the Journal of Financial Planning. While 4% is the headline number that’s most remembered from Bengen’s article, there are several critical assumptions underlying his conclusion:

• He assumes a portfolio of 50% to 75% equities. He found that a portfolio with an equity allocation outside this range would see its longevity erode, sometimes substantially, based on historical market returns. For many retirees, an equity allocation of more than half of their portfolio is hard to stomach. That’s particularly true now, given the uncertainties brought on by COVID-19. But some historical perspective may help. Bengen’s analysis covered markets during the 1929 crash and the subsequent Great Depression, World War II, the Vietnam War, stagflation in the 1970s, and the market crash of 1987.
  
• The portfolio is rebalanced annually. I point this out because of just how difficult it can be. Imagine retirees at the start of 2009. Having watched their life savings drop by 30% or more in 2008, it’d be difficult to buy into more equities to rebalance the portfolio. The same may be true today. Yet that’s exactly what they’d need to do if they were relying on the 4% rule.
• Bengen assumed market returns without fees. He used historical market returns, for the most part, that weren’t reduced by mutual fund expense ratios or advisor fees. That’s a reasonable assumption for DIY investors in low-cost index funds. For those in pricey funds with expensive advisors, however, the 4% rule may not work as well.

It’s important to note that while Bengen used historical market returns for the most part, his analysis also included projections of future returns. For those future years, he assumed a 10.3% stock return, a 5.2% bond return, and a 3% inflation rate. And that brings us to the 4% debate.

The 4% debate

Many today believe that 4% is too rich. They argue that given the lofty equity valuations (the price/earnings ratio of the Standard & Poor’s 500 Index still exceeds 20, even after the recent market declines) and low interest rates, we shouldn’t expect market returns to reach historical averages. In other words, don’t count on a 10.3% return on stocks or a 5.2% return on bonds.

Some financial advisors distrust the 4% rule because they say it fails to account for market fluctuations, among other reasons. Bengen’s rule, however, does account for market fluctuations. He spent most of his 1994 article on that very topic, even naming major market corrections after his interest in astronomy, such as calling the 1973–1974 recession the “Big Bang.”

And given market valuations and interest rates, it’s reasonable to believe that we can expect even lower stock and bond returns in the near term. (Exactly when, however, I have no idea. I predicted interest rates would rise in 2010.) That brings us to the 4% budget and one aspect of Bengen’s article that deserves more attention.

The 4% budget

Perhaps recognizing that no reasonable withdrawal rate is foolproof, Bengen extolled the benefits of reducing withdrawal rates, even if temporarily:

However, the client has another option to improve the situation for the long term, and that is to reduce—even if temporarily—his level of withdrawals. If the client can manage it without too much pain, this may be the best solution, as it does not depend on the fickle performance of markets, but on factors the client controls completely: his spending.

This realization led me to focus more on what I call the 4% budget than trying to discern the perfect withdrawal rate. Retirees should focus on how they’ll spend the money they withdraw each year from their retirement and taxable accounts. Specifically, what portion of the 4% (or whatever amount they take) will go to necessities, and how much will go to wants.

Needs vs. wants

It’s here we must recognize that not all 4% withdrawal rates are created equal. Imagine 2 retirees at age 65, both relying on the 4% rule to guide their withdrawals. On the surface, they appear to be following the exact same approach with the same risks and rewards.

Now let’s examine their 4% budgets. Let’s imagine that the first retiree needs the full 4% just to survive. Should their withdrawals fall below this level, adjusted for inflation each year, they’ll have difficulty paying the bills.

In contrast, imagine that our second retiree needs just 3% of their investments to pay their bills. The remaining 1% goes to travel and hobbies. Such leisure activities may be important from a quality-of-life perspective, but not for survival.

Now our retirees couldn’t be more different. In Bengen’s article, he showed that at a 3% withdrawal rate, a retiree’s 50% stock/50% bond portfolio would last at least 50 years across markets that included the early Depression years, the 1937–1941 stock market decline, and the “Big Bang.” Thus, a retiree who could live on a budget of 3%, or perhaps 3.5%, has the flexibility to survive major market meltdowns that could, in theory, sink a retiree who needed the entire 4%.

In fact, the flexibility to reduce annual withdrawals by just 5% can have a profound effect on a portfolio. As Bengen explained:

As an example, let us return to the 1929 retiree. At the end of 1930, as he is about to make his second annual withdrawal, the market has already declined about 30 percent from the end of 1928, and there looks like more trouble ahead. If he reduces his 1930 withdrawal by only 5 percent, and continues to withdraw at this reduced level during retirement, by 1949 he will have 20 percent more wealth than otherwise, which can be passed on to his heirs. After 30 years, the wealth is 25 percent greater, and the advantage continues to grow over time.

Debt

Eliminating debt before retirement can go a long way to giving a retiree the flexibility to reduce withdrawals in a down market, as we’ve experienced so far this year. Here again, imagine a retiree with no debt versus a second retiree who spends 25% of his 4% budget on debt payments. They may both be following the 4% rule, but they’re as similar as lightning and lightning bugs (apologies to Mr. Twain).

The 4% rule and early retirement

Much of my thinking on the 4% budget has come from the FIRE (Financial Independence, Retire Early) movement. As the FIRE movement picked up steam, many were quick to point out that applying the 4% rule to somebody retiring in their 30s or 40s was foolish. Some have even turned this into an outright attack on the FIRE movement itself.

Critics are right to question whether it’s reasonable to apply the 4% rule to someone retiring at 35 or 40. Bengen found that a retirement portfolio would last 50 years through all the markets he examined at a 3% withdrawal rate, and perhaps even a 3.5% rate. But it didn’t last nearly as long at a 4% withdrawal rate. In rare cases, the 4% rule didn’t survive beyond about 35 years.

Yet, even here, the 4% budget is critical in 2 respects. First, can an early retiree live off just 3% or 3.5% of their savings? Second, do they really plan to live the next 65 years without earning a dime, or do they have skills they can put to work in a way that’s consistent with the lifestyle they want to live? The answer to these questions is arguably more important than a debate over the 4% rule.

Some may question whether having to work, even part-time, is really “retirement.” Perhaps it’s not, at least by traditional standards. But as someone who retired twice by the age of 51 and hopes to retire at least 3 or 4 more times, I feel retired even as I type these words.