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Why the 4% rule is broken

Why the 4% rule is broken

| March 28, 2016
Rules of Thumb; Retirement

"I always like to look on the optimistic side of life, but I am realistic enough to know that life is a complex matter." - Walt Disney 

Let's going to break down what is perhaps the most broadly used rule of thumb in financial planning - "You should only pull 4% of your assets as retirement income."  It's used so pervasively in the financial planning community that it almost seems like law. And it's broken. If you read our previously mentioned insights, you may understand how we define a rule of thumb: a principle with broad application that is not intended to be strictly accurate or reliable for every situation.  There is none more true to this definition than the 4% rule. 

What does the 4% rule actually mean? This rule is supposed to be an appropriate distribution rate for a 30 year retirement, preserving purchasing power and maintaining or growing principal. A core assumption is higher interest rates. Perhaps back when a 5 year CD paid more than 1% the rule made much more sense. When fixed income was in a bull market and interest payments helped to generate income, preserve capital, and even generate gains to keep up with inflation. Not to mention 4% is supposed to be a sustainable number which should optimally leave wealth for the next generation. Considering the low interest rates of today, the portfolios of yesterday just may not be able to keep up. 

Not everyone is alike! Just as the life of your mother or father is dramatically different from your own life, so will your retirement be very different from theirs. According to the CDC, as of 1900 - at birth, average life expectancy was 47.3 years of age. Think about that for a moment. Who needed retirement in 1900? The idea of not working and enjoying it for decades is a relatively new concept! As of 1950, at-birth life expectancy grew to 68.2 years.  Retire somewhere between 62-65 and the need for retirement income was relatively minimal. And now we're living even longer and the pressure on our financial assets to last is tremendous! The latest tables are as of 2010, the average life expectancy is 78.7 at birth. At age 65, life expectancy is another 19.1 years.

Just to throw a wrench into it: What about variables? 4% works great in a vacuum. But what if you want to leave much more to the kids? What if you want to bounce the last check on the way to the grave? (Please note the second is a virtual impossibility.) 

Here's our take: we believe the 4% rule is absolutely broken. However, it's still a decent starting point for conversation and a simplistic guideline as to what our retirement savings goals should look like. Retirement income is a sliding scale that needs to be fine-tuned, over time. Customization should take into consideration length of distribution(age), wealth, income needs, risk of investments, interest rate environment, market volatility, legacy intentions, health and many other factors.  As with other rules of thumb, take them for what they are - generic guidelines. Don't follow a rule of thumb blindly, take the time to work with one of our advisors to learn what you really need for a gainful retirement.