Promoting Financial Literacy

Why the 4 Percent Withdrawal Rule Doesn’t Apply to Most People

I recently read “5 Ways to Cheat the 4 Percent Withdrawal Rule” and felt the need to pass it along and to add my perspective.  Like all articles dealing with how much money to “safely” withdraw from your portfolio during retirement is the assumption that one actually has money to withdraw from their portfolio.  Since most people either retire in debt, with no savings, or limited savings, we can understand why articles like this have a limited audience.  So before you read the article which by the way I think is excellent—let’s determine who might benefit from what the author believes.

Let’s create 5 hypothetical families that are entering retirement and make them identical with regards to age, genders, expenses, lifestyle, pension and Social Security, etc.  The only thing we vary is the amount of money they have saved in their portfolio.  For simplicity let’s assume each family receives a $30,000/year income from pension and Social Security and have living expenses of $50,000/year.  This means there is a $20,000 per year income versus expenses shortage.  The author of the article says that if one of the hypothetical families had savings of $500,000 then if they were to withdraw 4% a year from it or in this case $20,000 there is a very good chance that the money would last for 30 years.  I agree.  But who really cares.  Most people that reach retirement arrive in one of 5 ways—which is why the 5 hypothetical families.  They are as follows;

1)    The first arrives with no savings and in debt.

2)    The second has no debt but very little savings.

3)    The third has some savings but nowhere near the $500,000 required for their money to last at a 4% withdrawal rate.

4)    The fourth has savings somewhere in the vicinity of the $500,000.

5)    The fifth has significantly more money than $500,000.

So what’s clear is that the article only applies to those families that are in the fourth case.  If you are in case 1, 2 or 3 the 4% rule is meaningless and you should look at the very real options of a) continue to work full or part time, or b) reducing your expenditures  or c) some combination of a) and b).  If you are fortunate enough to be in case 5 then the article also does not apply because you are not going to run out of money.  So the 4% rule applies to a very limited audience, or what I call the case 4 family.  If it is your family I would pay attention.

There are a few observations I would like to further make as it applies to real world behavior.  The first is to say that while the largest mutual fund companies in this country have tried very hard to convince the newly minted case 4 retiree to invest in what I would call their “Withdrawal” mutual funds they have had very little success.  Let me repeat.  They have had very little success.  It seems most people are happy entrusting their money to theses same mutual fund companies while they are trying to save money in the myriad “Target” mutual funds they provide.  But when they retire they opt for something they perceive as safer and typically money flows into the hands of insurance companies.  I suppose this happens because people are inherently afraid of these type of “Withdrawal” mutual funds for whatever reason and have difficulty committing to them despite the fact that all the evidence points to a higher probability of success.  When the mutual fund companies add a level of certainty to their funds I suspect they will be a huge success.

This brings me to my second observation.  The author of this paper has over a billion dollars under management at his firm.  This does not happen by having clients in cases 1, 2 or 3.  Advisors that have reached a certain level of success focus their efforts on those families that are in cases 4 and 5 and in fact case 5 clients make up the bulk of their practice and income.  So if you are looking for an advisor, and you are a case 4 potential client, make sure your advisor is well versed in handling case 4 portfolios.  If it were my money, I would ask them to provide you with specific names of clients that were with them for over 15 years and went through the 2000-2002 as well as the 2007-2009 market declines to see how their withdrawal strategies held up.  I suspect they might not be able to provide you with one name.  If they can’t, I suggest you move on to the next advisor.

For those that want further insight on sustainable distributions, please refer to the February 2010 Journal of Financial Planning article entitled A Simple Dynamic Strategy for Portfolios Taking Withdrawals: Using a 12-Month Simple Moving Average.

1 Comment

  1. July 26, 2014    

    Great post with useful information. I have learned something new from here.

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