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  • Writer's picturePeter Mu, CFP® ChFC®


Updated: May 21, 2020

The 4% rule, or the “safe withdrawal rule” is a model by which the financial service industry use to recommend the amount of income a retiree should receive from a portfolio without running out of money.  It is based on the idea that a conservatively allocated portfolio should grow at least 4% a year and if the retiree only lives off of this income without raiding into the principle it should last a lifetime.  This model is illustrated in the chart below.

​In my opinion over reliance on this rule of thumb grossly underestimates all the cost-of-living factors and produces no safety at all.  Here are some areas you should consider. Outdated bond model and $1 success.  The Monte Carlo simulation is a common tool used in the financial service industry to illustrate the chances of success and failure of a portfolio given uncertainties in market returns.  It is a mathematical and quantitative analysis based on past market return data and there lays the first problem.  For this model to work it assumes that history will repeat itself and that the future can be reasonably predicted.  The bond rates today have been in historically low environments comparing to the 70s, 80s, and 90s.  The calculation based on historical bond rates will grossly overestimate the return on fixed income component of the portfolio.     Additionally, each iteration of Monte Carlo simulation is considered a success if there is $1 left in the portfolio and that is simply not how consumer psychology works.  I can’t imagine watching my portfolio go down to $1 and still consider my investment a success.   Long term care, life events and our families are not accounted for.  The 4% model also fails to consider unexpected events that happen in life.  We are married and remarried sometimes.  Children and grandchildren go to college, our parents and other family members need our help.  Cars break down.  Washer/dryer and the roof need replacement…the list goes on and on.  People who are forced to use this model are one long term care event from catastrophic financial ruin. Probably the biggest problem with this model is that it fails to consider human behavior.  Our survival instincts urge us in wrong directions, our emotions cloud our judgment and our perceptions lead us to patterns that are not there and neglect obvious signs of distress.  Compounded by the hype and horror of media influence our cognitive and logical decision making process breaks down.  Marking timing, stock picking, and track record investing are all examples of consumer behavior that contributes the suboptimal returns individual investors experience.  According to the Dalbar(1) study individual investors earn only 3.8% return over a long period of time. Changes in Taxation.  Our income tax might not remain the same today.  If you study the history of our economy you might notice that the top marginal income tax rates have been very high comparing to where it is today.  The fluctuations can be attributed to government’s political and economic policies including warfare, health care and other social programs.   If taxes go up in the future our effective net after tax income will go down. Retirement spending isn’t linear.  Some financial advisors segment retirement years into “go-go” years, “slow-go” years and “no-go” years.  Go-go years are the first few years of retirement.  They are often filled with exciting new hobbits, a lot of traveling and all the fun things people always wanted to but never got to do while they were busy at work.  Retirement income cash flow demand is often very high.  Slow-go years are often filled with a lot of golf, gardening and other leisure activities.  The cash flow demands may be lower.  During slow-go years many people begin to experience more health related issues and increased health care related expenditures.  A properly designed retirement cash flow should take this into account. The 4% model does not allow estate planning through gifting, lending, or other methods because the entirety of accumulated assets are designated to produce retirement income it is impossible or very difficult to plan estate transfer and intergenerational wealth preservation. I think liquidity should be redefined to give the proper context for our discussion here.  Liquidity should not be your ability to go to the bank and withdraw all the money all at once.  While it is technically possible no one will actually do that.  This money is committed to producing income and while the investor has the freedom to allocate the investment however he/she likes, the money cannot be used for any other purposes such as a health care event or unplanned expenditure.  Once the principle is compromised there isn’t enough to produce the same income as before.  We call this phenomenon as having allocation liquidity and no consumption liquidity.   In conclusion, the living-off-of-interest, or the 4% model, requires that the future market repeats its historical performances, income taxation never changes, your retirement income demands remain linear, emotionless, robotic investor behavior, less than satisfactory legacy achievements and that your life unfolds perfectly and predictably.  Other than that, it is just fine.   To truly bring safety and security to an uninterrupted income stream in retirement you must consider all the factors.  Protect your wealth all the way to the end, own equities, truly diversity your portfolio, rebalance on the highs and lows, and orchestrate a variety of assets to produce income regardless of market conditions or life expectancy.  Speak with a financial professional about your ideas and concerns and schedule regular meetings to discuss changes that are happening in your life.  You have to own this 100%.

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