William Bengen, a financial planner, wrote an article in 1994 that rocked the retirement planning industry. The paper’s central argument was that retirees can be led astray by utilizing average returns and inflation while preparing for their financial future. The ebb and flow of actual, historical data should be used instead.
Mr. Bengen came to the conclusion that a retiree could take an initial withdrawal of around 4% of their savings if they planned on retiring for 30 years. After that point, the sum could be readjusted annually to account for inflation. He reasoned that this strategy would hold up through any retirement of 30 years or more since 1926. Additional studies have backed up these findings, which are from shortly after the Civil War.
The 4% Rule was so well conceived. Members of the FIRE community use it now to determine when they can retire. Some financial advisors argue that the rule overestimates how much a retiree can spend, while others argue that it significantly underestimates it. Many scholarly works have examined the rule from various perspectives.
Numerous people don’t realize that the 4% Rule is merely one of numerous ways to withdraw money throughout retirement. Further, I would argue that many retirees would be better off with other options. If you’re looking for options outside the 4% Rule, these five are solid picks.
1. Guardrails Approach
The fact that retirees are typically left with more money after death than when they retired is a little-known flaw of the 4% Rule. After 30 years, retirees can have as much as six times their initial investment. Why? The worst year to retire in history, 1966, is the basis for the 4% Rule. The safe initial withdrawal rate is often greater than 4% and can be significantly higher. Spending restraints are one solution to this issue.
The goal is to restrict annual withdrawals to a certain range. A retiree using the 4% Rule (a constant dollar method) could, for instance, begin with an initial withdrawal rate of 5%. According to the data, this strategy will fail roughly 20% of the time if inflation is factored in annually. To deal with this, one solution is to establish a 4% floor and a 6% ceiling.
The retiree would make an annual inflation adjustment to the withdrawal amount. However, they would first determine what share of the portfolio was being withdrawn before making the withdrawal. If the total is more than the 6% ceiling, they will adjust it down to that level. They may increase the withdrawal to the lower guardrail if it is less than 4%.
Jonathan Guyton and William Klinger, who created the Guyton-Klinger withdrawal strategy, popularized guardrails.
2. The Variable Percentage Withdrawal Strategy of the Bogleheads
Since the 4% Rule accounts for inflation each year, it is considered a constant dollar method. After accounting for inflation, retirement spending is assumed to be constant. The Bogleheads Variable Percentage Withdrawal Plan, on the other hand, does not account for price changes over time. Instead, it takes into account a number of variables to calculate the withdrawal rate annually in retirement:
- Age
- Asset Allocation, and
- Portfolio Balance
The retiree consults the author’s own chart for this method (available here). The benefits and drawbacks of this withdrawal method are varied.
One upside is that running out of cash is quite unlikely. The strategy’s reliance on financial gains explains, in part, this phenomenon. To further fine-tune the withdrawal amounts, it considers the retiree’s asset allocation. In the end, it lets retirees begin their withdrawals at a higher rate.
One potential drawback of this strategy is that it can cause unpredictable spending patterns in response to market fluctuations. One’s real spending may decrease after retirement if they encounter a bear market with substantial inflation. A retiree’s savings may grow over time, giving them more discretionary income even as they become less likely to spend it. Of course, that is also commonly the case when applying the 4% Rule.
3. Yale Spending Rule
Like retirees, endowments have the challenge of balancing the need to distribute income while maintaining or increasing the value of the endowment fund over time. In times of market turmoil or rising inflation, this might be challenging.
Yale and other universities have adopted a novel expenditure policy to achieve these double aims. The annual payouts from the endowment are determined in a broad sense as follows:
- 70% of the total dividends from the preceding year, adjusted for inflation;
- 30% of the average fund balance over the previous three years multiplied by a predetermined expenditure rate (usually about 5%).
Keep in mind that this is a hybrid of the conventional fixed-dollar method with the 4% Rule and the more adaptable market-based strategy. To mitigate or amplify the impact of inflation and the market on retirement expenditures, a retiree could adjust the 70/30 split given above.
James Tobin, winner of the 1981 Nobel Prize in Economics, popularized this strategy and gave it another name: the Tobin Spending Rule. At one time, MIT used this method.
4. The Dividend Spending Rule
Some retirees focus more on global wealth, while others are simply delighted not to have to worry about running out of money. In this section, people seek advice on how much they can spend during their lifetimes without jeopardizing their legacy. In some scenarios, the Yale Spending Rule could work. James Garland came up with an alternative method.
From 1995 to September 2012, Garland held the position of president of The Jeffrey Company. The company first began operations in 1876, when it created a tool for mining coal beneath the earth’s surface. It eventually sold off its business and is now running as an investment manager for the original owner’s heirs.
Based on his findings, Garland determined that the corporation could pay out 130% of its investments’ dividends while still keeping enough capital to give future generations an inflation-adjusted version of the current payout. His studies are collected here.
5. Spend Safely in Retirement Strategy
I think many retirees would benefit from the last tactic, which is also my favorite. Both an article and a video explaining the tactic can be found on my site. There are only two parts to this plan:
Social Security benefits should be claimed after age 70 (though the lower-earning spouse in a pair may do so earlier), and annual spending should be calculated from savings using the same technique used to compute RMDs.
The end result is a simple method that can be implemented anywhere. Inflation is taken into account to some extent, using Social Security payments as a basis. The RMD feature allows it to adjust to fluctuating market conditions.
Summary
There is no withdrawal method that is foolproof. Retirees need to have the capacity to adjust to changing personal and economic conditions, as well as an understanding of the tradeoffs associated with any approach. When it comes to planning for retirement, the 4% Rule is a respectable method; nevertheless, one of these alternative techniques might prove to be more realistic when the time comes for one to actually retire.
Adapted from Rob Berger
Rob is a Contributing Editor for Forbes Advisor, host of the Financial Freedom Show, and the author of Retire Before Mom and Dad–The Simple Numbers Behind a Lifetime of Financial Freedom. He graduated in 1992 from law school and has written about personal finance and investing since 2007.
