I’m often asked what I think about the “4% rule” for spending in retirement. According to this rule of thumb, an individual who is planning on a 30-year investment horizon and is holding a broadly diversified and balanced investment portfolio of stocks and bonds, can—with a reasonably low probability of running out of money over 30 years—spend an amount equal to roughly 4% of their total retirement portfolio in the first year, and then adjust that withdrawal every year thereafter for inflation.

One of the easiest ways to see where this “rule” comes from is the chart below.

Maximum inflation-adjusted withdrawal to fund 30 years of spending

Note: Using historical performance data, the chart shows what dollar amount could have been withdrawn from a portfolio (rebalanced monthly to a fixed asset allocation) to exactly exhaust that portfolio over 30 years.

Inflation is represented by changes in the non-seasonally adjusted CPI-U (source: U.S. Bureau of Labor Statistics). U.S. stocks are represented by the following benchmarks: S&P 500 (1926-1970); DJ Wilshire 5000 (1971-April 2005); MSCI BMI (since May 2005). For Bonds: S&P High Grade Corporate Index (1926-1968); Citigroup High Grade Index (1969-1972); Lehman Brothers U.S. Long Credit AA Index (1973-1975); Barclays U.S. Aggregate Bond Index (since 1976).

Assuming you had started spending in any month from January 1926 to July 1979, the chart shows how much you could have spent historically following an inflation-adjusted spending rule, so that you would have exactly exhausted your portfolio after 30 years. The data show that if you wanted to steer clear of historical scenarios where you spent more than the portfolio could produce over 30 years, you’d have had to start with an amount equal to 4% or less of the starting balance. Spending 4% didn’t lead to success 100% of the time (all three lines dip below 4% in the late 1960s and early 1970s), but was close to the lower limit in the data. Also note that since this is based on costless index returns, spending here has to include whatever fees you paid to make these investments. So there you go: “4% adjusted for inflation” is a plausible spending guideline based on the history and this assumed spending pattern.

Now, when economists hear about this “4% rule” for spending in retirement, they tend to cringe. (At least one well-known one has written an article explaining some reasons why.) One of the biggest issues they point out is, as the chart shows, that the “4% rule” in most cases tends to leave a lot of money unspent (at least over the 30-year horizon), and is hence potentially inefficient. Perhaps even more critically, the rule doesn’t allow, or really even envision, that people would revisit their spending rate going forward from the starting point. For example, if you start spending an amount equal to 4% of your portfolio, and then the market ends up going up much more than inflation, how come you can’t increase your spending by more than inflation? Presumably your horizon isn’t longer this year than it was last year, and now, 4% of the portfolio would be a higher number than last year’s 4% plus inflation. Beyond this, there is of course the “what-happens-if-I-live-to-year-31-risk” that the rule ignores entirely.

All valid criticisms. And there are alternative spending rules (based on academic work that has existed for decades) that could potentially be better—or at least more complete—solutions in a variety of ways. However, I would argue that most of these alternative, model-based approaches are only obviously superior if a retiree fully understands and accepts the models and framework used to derive the optimality results. The models and embedded behavioral assumptions are complex, and, while intuitive to economists, may not “feel right” to people in the real world.

As an example, consider an individual with no desire to leave an estate, whose required absolute minimum needed spending will be completely funded by Social Security, and who is not facing any uninsured risks. (Just go with it for a minute). We can use a “standard economics” framework to think about optimally spending whatever assets they have accumulated. But first we need to make still more assumptions about important issues—specifically: constant relative risk aversion utility with intertemporal elasticity of consumption equal to one-third, a pure discount rate of 1% per year, a real (and, to keep things simple) riskless rate of return of 2.5%, and mortality expectations in line with a 50/50 average male/female (unisex) version of the RP2000 mortality tables. Assuming one even understands what they mean in the first place, these are each debatable assumptions.

Anyway, in that theoretical world, for an individual attempting to optimize spending, you’d get the pattern in the chart below. Spending starts out about 15% higher than the 4% rule would prescribe, but after age 85 (assuming one lives that long), spending is lower than the rule would have prescribed. The pattern reflects that in the economic framework, people are looking forward as they are optimizing, and trading off the higher likelihood of not being around against the lower satisfaction they will get from spending less if they are around. The 4% rule is, in contrast, designed to target a fixed, minimum level of spending over a specific period of time.

Spending in a "standard" model

I’ve shown this kind of result to a few people and gotten different reactions. A big one is that, on its face, the assumption that a retiree faces no uninsured risks is just silly. Many are also uncomfortable with the notion that if they make it to 90, they are going to be spending 30% less than at age 70. What do you think?

Bottom line, the 4% “rule of thumb” is just that—a rule of thumb. It’s based on an understandable, if not particularly complex set of assumptions about behavior and historical data on the markets. And as a baseline guide for setting individuals’ spending expectations at retirement, it’s in the ballpark, generating an initial spending recommendation that is arguably close to what comes out of a more complicated analysis.

While it’s not perfect, and it’s easy to be a critic, it’s tough to ask for a lot more than that in as simple a package.


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