Ep 21 - How Much Can I Spend in Retirement? Why the 4% Rule Gets it Wrong

Retirement is not a game of precision.

It's a practice of constant adjustment.

No model will ever know the exact path ahead.

Every study you've read is about the past, and every tool you've used is some projection of the future that will never quite unfold the way in which we imagine.

So, stop trying to model your current decision on a battle we've already fought or the one that the tea leaves say is about to come.

Hello, friends.

This is Tyler Gardner, welcoming you to another episode of your Money Guide on the Side, where it is my job to simplify what seems complex, add nuance to what seems simple, and learn from and alongside some of the brightest minds in money, finance, and investing.

So let's get started and get you one step closer to where you need to be.

I've always had a hard time with the 4% rule.

Not because it's completely wrong, but because it's overly simplistic, it's rooted in worst-case scenario thinking, and over time, it's been treated as gospel for one of the biggest financial decisions of your life.

When to stop working and start living.

Or in other words, how much money can I spend each year and still be okay for the rest of my life?

In today's episode, I'd like to explore five reasons why you should give some serious thought to the 4% rule, if you will, before adopting it for your own purposes.

And by episode's end, hopefully you will not only know exactly what the rule is and where it comes from, but also how it might impact you and your choices moving forward.

And if there might be even a better way to think about your money than by adhering to a rule that was, well, never meant to be a rule.

And as always, if any of this is helpful, please consider leaving a review, as it helps more people find us and join the conversation.

If you've got feedback or ideas, shoot me a note directly at socialcapconnect at gmail.com.

I read every message and the show is always and forever for you.

Reason number one, why I'd like to challenge the 4% rule.

It was born from fear-based thinking, not freedom-based thinking.

It all started in 1994 with a man named Bill Bangen, who, by the way, is a fantastic thinker, and it's certainly not his fault that we took his research, butchered it, and turned it into the holy gospel of never spending a dime in retirement.

But his research and findings have indeed gone on to haunt retirement calculators for the past three decades.

Bangin's insight was straightforward, but revolutionary at the time.

He wanted to figure out how much someone could safely withdraw from their retirement portfolio each year without running out of money.

And the good news, and why I really like Bangin, is that unlike the countless financial voices we hear from today who continue to regurgitate the 4% rule to all of their clients, pretending it's based on their own careful analysis, Bangen did something that most of us never do.

He went to the data itself and he ran the numbers himself.

Specifically, he looked at every rolling 30-year period in U.S.

history going back to the early 20th century, through the Great Depression, through the high inflation of the 1970s, through recessions and recoveries.

What he found was that if a retiree had a balanced portfolio, let's say 50% stocks and 50% bonds, they could withdraw 4% of their starting balance in the first year of retirement.

and adjust that amount each year for inflation and still have a very high likelihood of never running out of money over a 30-year retirement.

And that's all great.

This wasn't some random guy's opinion.

This was math.

It was stress tested and it worked.

Even in the worst historical markets, 4% tended to hold up, meaning simply there were very few periods in which someone would have actually run out of money.

But here's the catch.

And it's the part that almost everyone skips over when quoting the 4% rule.

Bangin was solving for the worst case scenario.

His question wasn't, what's the most efficient way to spend down assets in retirement?

Rather, it was, what's the safest withdrawal rate that would have worked during the most brutal 30-year market stretch in U.S.

history?

Am I really the only one who sees a problem with the way we're framing that?

Hey, how can I design my life to survive the single worst case scenario in market history?

So we inherited this safety-first mindset, or I'll just say fear-based mindset, and now sometimes it's referred to as safety max, and it became the standard framework of advisors everywhere.

Understandable.

As in a profession built on risk management, finance, it feels better to tell a client they'll be okay even if the market collapses tomorrow.

But when you build your retirement plan around the single worst historical outcome in market history, you end up anchoring your life life to fear, not likelihood.

Cut to a few years later, 1998, and the Trinity study, which many of you have probably heard of, comes along and reinforces Bangan's work.

Great, more data to keep us terrified.

Professors from Trinity University, Cooley, Hubbard, and Waltz, ran their own analysis on different stock bond allocations and withdrawal rates over 15, 20, 25, and 30-year time horizons.

And again, 4% rule passed with flying colors.

If you had a 75 stocks, 25 bonds split portfolio, you'd be safe 96% of the time.

But again, the focus was on failure rates, on what could go wrong, rather than what was likely to go right.

And the 4% rule was hence put into practice as the maximum amount anyone would dare withdraw from their portfolio moving forward.

in fear of winding up destitute under a bridge peddling old crisscross CDs in exchange for a warm meal from time to time.

Reason number two, I'd like to challenge the 4% rule.

Building on the above, we have ignored entirely the massive upside data that Bangin and the Trinity study have presented.

This inherited history of 4% rates might be the one moment in history where the story wasn't written and told by the winner, but rather by these apparent hypothetical losers.

So here's what the winners would have shared about these studies.

Let's take the Trinity study, this inherited gold standard for validating the 4% withdrawal rate.

It actually proves something far more optimistic.

People with equity-heavy portfolios didn't just succeed, they ended up extremely wealthy and could have spent far more money than they did throughout their lives.

Based on a starting hypothetical portfolio of a million bucks, those who invested 50% stocks and 50% in bonds had a median portfolio value after 30 years of $2.97 million.

Those who invested 75% in stocks and 25% in bonds had a median portfolio value after 30 years of $5.9 million.

And oh boy, do I love sharing this last one to justify my life's stance on why bonds are nonsense in the long run.

For those who had invested 100% in stocks, the median portfolio value after 30 years was $10,075,000.

Over $10 million,

and that's already adjusted for inflation.

Boomtown, my friends.

And you wonder why I advocate for 100% stock allocations, even well and deep into retirement.

This isn't me being ridiculously risky.

This is actually having me be highly risk-averse based on statistics.

Far from potential scarcity, the majority of hypothetical investors wound up with portfolios much higher in value than their initial holdings by sticking to this 4% rule.

Yet, and I can hear some of you saying this right now, we continue to focus only on these two failure years, 1965 and 1966, the two years in which these hypothetical portfolios did did actually go to zero with certain allocations, instead of focusing on the 28-plus scenarios where retirees ended up with millions left untouched on their deathbed or their hypothetical deathbed.

Why?

Because the narrative got hijacked by the fear of running out, not the possibility of living well.

It's like when I used to tell people that I loved teaching.

and got fairly paid and enjoyed my summer months of vacation every year.

So many people hated me for saying that and couldn't begin to believe that life could be all right as a teacher and that life might actually turn out to be okay for all of us.

And not just okay, but these hypothetical multimillionaires could have spent way more when they had the opportunity and mental clarity to do so.

Reason number three, I'd like to challenge the 4% rule.

It applies rigid math to a incredibly dynamic world or incredibly dynamic humans.

One other thing we rarely talk about with the 4% rule.

In those 1965 and 1966 failure cases, you need to keep in mind a couple things here.

Yeah, the markets struggled and inflation soared.

Yeah, it was a crappy time to invest.

Yet, these hypothetical test case retirees kept blindly withdrawing 4% each year no matter what.

In other words, these automatons were apparently very good at following this rule from one year to the next, even when their portfolio and the market was tanking.

That's not real.

That's not how we'd respond.

Rules imply rigidity.

They imply enforcement.

Rules are for board games and tax courts and kindergartners with sticky hands at day's end before they head home and leave a trail of the class's collective mucus throughout the house.

Sorry, that was probably an overly aggressive image.

I could have softened that one.

But retirement?

Retirement's real life, and it's messy, no matter how much we want to make it it completely clear from chaos.

It's emotional.

It's shifting.

It's dynamic.

It certainly doesn't follow a straight line, and it definitely doesn't follow a single number carved in stone.

And yet, we continue to call this thing the 4% rule, not the 4% framework, not the 4% starting point, a rule, as if we would turn to one another and say, well, Frank, I know I can live on less.

Or I know I need to live on more, but you know what, buddy?

4% is 4%.

Got to stick to it, or I'm doomed to be selling those crisscross CDs under the bridge.

This language alone does something subtle and damaging.

It makes us feel like deviation is failure, like any variation up or down is reckless.

As an example, seriously, just propose to any financial advisor these days that you might consider withdrawing 6% from your portfolio, and it will be as if you just questioned the godlike stature of the golden doodle in the hierarchy of our canine friends.

Sacrilege, pure sacrilege.

The truth, as we have seen, is that this so-called rule was never meant to be a rule in the first place.

Bangin himself has said repeatedly that his original work was designed as a guidepost, a safe starting withdrawal rate based on historical backtesting, not a permanent prescription.

In an interview with Morningstar, he says, I never intended it to be a rule.

I just found that 4% worked across the worst-case historical scenarios, but people started treating it as gospel.

That's like me saying, hey, honey, I found if I don't go down to the store, I'm less likely to get hit by a car.

Yeah, that doesn't mean we should now adopt a don't go to the store rule, especially if the majority of the time I go, not only am I fine, but I come home with Ben and Jerry's and a hetty topper.

Delicious, amazing, and I win.

What began as an ultra-conservative benchmark has now morphed into sacred doctrine and honestly, dangerous doctrine.

And this framing shapes our behavior.

It creates a generation of financially successful people who have won the game, but still refuse to leave the table.

I talk about this all the time in my social content.

According to a 2022 Schwab Modern Wealth survey, 63% of retirees with over a million bucks in assets say they're afraid of running out of money.

And I get it.

How could you not be afraid of running out of money if all you hear about is the 4% rule and the scenarios where people just ran out, even though very few ever do, and most wind up with more money than they started with.

Life is not a Monte Carlo simulation.

It doesn't unfold in neat little 12-month windows of 4% adjusted for CPI.

Some years, you'll spend more.

You're going to travel.

You're going to give, and you're going to live.

Other years, you're going to spend less, either because of frugality, caution, or you're just tired and want to stay home, or because you realize that some of the best moments in life are are actually the simplest ones that tend to cost next to nothing.

The real question isn't, are you following the rule?

It's are you making the most of your time and resources in balance over time?

So yes, it's worth knowing the math and learning the probabilities, but it's also worth appreciating that the actual math suggests we have a very high likelihood of being not just fine, but financially free for the remainder of our retirement.

The fourth reason I would like to challenge this 4% rule, and this is a big one for me, the fact that you'll be safe does not mean you'll be okay.

Even more so, it does not mean you'll be as financially free as you'd like.

What do I mean by that?

Going beyond my optimistic thinking from above and adding the necessary nuance and real potential for loss that we have to address in this episode, the one concept you need to understand above all else about your own retirement is sequence of returns risk.

This matters a lot.

Here's the idea.

Two retirees could earn the exact same average annual return over 30 years.

But depending on when the losses hit, one of them could end up just fine, actually with millions more than they started with.

And the other could end up, well, not so fine.

Not because they spent too much, not because they invested poorly.

In fact, they could have identically identically invested portfolios across asset classes, but rather because the market drew down at different times for both of them, namely in one case, right at the beginning of their retirement.

To illustrate why this concept matters so much and how it impacts our consideration of the 4% rule, I ran some numbers myself.

Let's say you retired on January 1st, 2000.

Congratulations, you just quit your job and walked directly into the dot-com crash, followed closely by the great financial crisis, and then topped off with a global pandemic.

Not ideal.

And while you started off with a million-dollar portfolio and withdrew 4% a year, inflation adjusted, your portfolio was cut more than in half within the first three years of retirement.

as we saw market downturns in the S ⁇ P of negative 10, negative 13, and negative 23% respectively in 2000, 2001, and 2002.

Now, you didn't do anything wrong.

In fact, you did everything you were told to do.

The market just happened to fall repeatedly before it had a chance to rise.

And unfortunately, those early percentages ate away at your principal at the worst possible time.

And even though the years that followed were strong, And even though the S ⁇ P posted a healthy 7.5% average real return over the next 25 years, you ended up working from a much smaller base.

So those 7.5% gains were drastically lower on your $500,000 starting principal than they would have been had you not experienced three massive hits in your first three years.

But, and here's where we tie this to the 4% rule.

Interestingly, even if you had retired in 2000, and had such an abysmal sequence of returns, do you know you would have ended up 25 years later with about as much money as when you had retired?

Meaning on the Trinity study or Bangin scale of safe to not safe, you were in fact considered safe.

But were you okay?

Because you had originally planned on $40,000 a year of income from that million bucks, and within just a few years, that 4% is not $40,000, but actually less than $20,000.

Bluntly, this is why I don't even know how we allow ourselves to talk in percentage terms about this, as the percentage means nothing.

The principal and the annual spending mean everything.

As your principal changes, as it inevitably will, so too does this 4% concept.

And that's the real risk of the sequence of returns.

Not dying broke, as even in 2000, you would have been labeled just fine according to the Trinity study, but in living constrained, as it doesn't take any academic research to appreciate that this hypothetical retiree got screwed and the four percent rule did not come close to delivering a life of freedom from worry about running out of money.

And even our modern retirement calculators and tools, including these Monte Carlo simulations that advisors love using to show you some statistical probability that you will in fact be safe with 90% odds, they can't capture this.

Safe doesn't mean you lived the retirement you wanted to live.

They look at average returns and call it safe, meaning only you didn't run out of money.

And when this sequence is wrong, that damage is front-loaded and it sticks.

This is why timing matters more than math.

And it's why retirees in their early years should think not just about averages, but about buffers.

What accounts do you have in place to protect against the very scenario we just explored?

Do you have enough cash equivalents that aren't exposed to market volatility to get you through, let's let's say, a two to three year window?

If not, that's way more of a priority than coming up with some magic number from which 4% ultimately might leave you withdrawing 20K a year for your very survival.

So here's the solution.

And I'm going to propose we do something a little crazy, a little different.

Each year, we're going to pick our heads up and look at our portfolio and look at the markets.

Let's say the market just suffered a 20% loss from which it's not recovering too well and we were planning to retire.

Okay, maybe we hang in there for another year.

Or did the market just get hit in your first year of retirement and you were planning on taking a trip to Italy with the fam?

Ah, yeah, maybe Olive Garden will have to do for this adventure.

Or flipping it, did the market just have a 25% amazing gain year?

and you were planning on being frugal and only taking 2% to make sure you were okay.

Well, congrats, the market has spoken.

And you're not just okay, you did great this year.

So take the dang trip to Italy and withdraw whatever helps you get there.

Just be alert and remain flexible.

No rule is going to help you with this.

Additionally, and this is crucial for your planning, this is where I would consider strategic rebalancing for spending.

Here's the principle.

In up years, when markets are strong and your portfolio is riding high, don't just celebrate the growth.

Trim the gains.

Harvest some of that appreciation and reallocate it into cash equivalents like high yield savings, short-term treasuries, or a money market fund.

That way, you always build up a piggy bank of spending reserves, not by selling in desperation during a down year, but by skimming off the top during a good one, aka doing the number one thing all of us want to do, but none of us actually do.

Sell when markets are high.

This way you've created created your own income buffer, your anti-panic fund, and you can go into those inevitable bear markets with the confidence that you don't need to sell stocks when they're down just to pay the bills.

This way, you respond to the market's dynamic nature with some dynamic nature of your own.

And finally, reason number five why I would like us to pause and challenge the 4% rule.

As is true of so much nonsense in modern financial planning, it assumes we're all the same and have very similar goals and values as it pertains to our money.

Because let's just state the obvious but often ignored truth.

4% of a million bucks is $40,000.

4% of 4 million bucks is $160,000.

Same rule, wildly different outcomes.

This is where portfolio size matters way more than withdrawal percentages.

Not for bragging rights, but because a larger portfolio gives you more flexibility, margin, and choice.

The math that matters isn't the percentage, it's the lifestyle the dollars can afford.

Personally, I can be fine living off of about $60,000 a year in Vermont, as most of it goes to buying my dog food for 200 pounds of hound.

So for me, my magic number is much smaller than someone else's.

And if I had $4 million in the bank, no way would I need to or want to withdraw 4%.

So the real conversation isn't about whether you can safely withdraw 3.8 or 4.1% in retirement.

It's about what you actually need and whether you've built enough margin to live that life comfortably through the volatility, through the inflation, through the healthcare shocks, and everything else life throws your way.

Namely, do you have that risk off allocation to protect your portfolio and your peace of mind during the down years?

Too many people fixate on the precision of the rule without ever asking the bigger questions.

What am I actually using this money for?

Do I need to spend all this money?

How much joy is it even bringing me each year and am I spending it in the right place?

This is also where asset allocation comes into play, because one of the most overlooked conclusions of the Trinity study, and confirmed by tons of follow-up research, including my own fun research, is that more equities actually increase the likelihood of success.

I've said this so many times, especially over longer time horizons, even though we're told by traditional finance voices to decrease equity exposure, stocks, and increase fixed income, bonds, as we age.

That is simply regurgitated, misguided information, because again, there's no one size fits all.

And if I retire with 250,000 bucks, I'll have a pretty hard time affording the lifestyle I want by overinvesting in fixed income according to some archaic formula.

I'll need way more growth than the person that retires with 4 million bucks.

That person could put it all in money markets and typically be fine for the rest of their lives.

That's the privilege of wealth.

All of the academic research supports your continued exposure to growth assets over fixed income assets to make it through the toughest markets we've faced, not the other way around.

Remember, the Trinity study found that the 75-25 portfolio had higher success rates than a 50-50 mix.

And recall, the median ending value of the 100% stock portfolio was over $10 million versus just 2.9 for the bonds.

Again, this depends on you.

It depends on your risk tolerance.

It depends on what you want to live off of each year.

So stop adhering to rules that might work for others and stop listening to me for all intents and purposes.

Decide what works for you and disregard some hypothetical test cases that existed in an empirical vacuum.

So after all that, where do we stand?

The 4% rule is not wrong.

It's just misunderstood.

It was built to survive the worst cases in history, not to guide the best of your future.

And when we turn it into gospel, we don't protect people.

We shrink their lives and their options.

So here's what I want you to take from this episode.

Retirement is not a game of precision.

It's a practice of constant adjustment.

No model will ever know the exact path ahead.

Every study you've read is about the past, and every tool tool you've used is some projection of the future that will never quite unfold the way in which we imagine.

So stop trying to model your current decision on a battle we've already fought or the one that the tea leaves say is about to come.

Instead, choose to be dynamic, flexible, and responsive to market movements.

And if you're lucky enough to build a big enough base in your lifetime, and this is why investing when we're young matters so much, then then we're given the privilege to forget about the concept of 4% altogether.

We can spend with joy, we can give with purpose, and we can live with the freedom we have worked so hard to achieve.

Thanks for tuning in to your money guide on the side.

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Until next time, I'm Tyler Gardner, your money guide on the side, and I truly hope this episode got you one step closer to where you need to be.