The 4% Rule: Why It Might Fail Your Retirement Goals?

There's a lot of rules of thumb for your retirement. As you're doing your retirement planning, following these rules of thumb could destroy your retirement. Hey, I'm Casey Weade, CEO and founder here at Howard Bailey Financial, also a certified financial planner practitioner, and we're here to talk about rules of thumb.

Now, throughout this video, if you have any questions that pop into your head, drop them in the comments section and I'll be sure to answer as many of those as possible. If you have ideas for me to create future videos, questions you'd like me to create videos around, drop that in the comments section as well, and I look forward to hearing from you. Now today, as we talk about rules of thumb, we're going to be focusing on one rule in particular.

We're going to be talking about the 4% rule. There's a few different rules we're going to cover. This is video number one in a four-part series.

We'll be talking about the rule of 100, the 10% rule, the 70% rule in today, the 4% rule, and how these could have a dramatically negative impact on your retirement if you're just following that rule of thumb. The bottom line is some of these can be helpful, but in large part, they're going to be helpful on your way to retirement, not when you're actually doing that retirement planning at the time of your retirement or even in those last few years leading up to retirement. You've probably heard of the 4% rule before, and we're going to talk about it again today.

This is something that is very important for us to understand as we're doing our retirement planning. The 4% rule basically says this, and it was created back in 1994 by a gentleman named William Bennegan. That was back in 1994.

I really want to emphasize that it is now 2024. A lot of years have passed. We've had 30 years of research now at our fingertips, and that means that we have more advanced tools.

We have more advanced analysis at our fingertips. This was a rule of thumb that basically said this, over a 30 year time horizon with a portfolio mix of stocks and bonds, a 50-50 mix is usually what's discussed, 50% stocks, 50% bonds. When you retire and you draw 4% out of your accounts at the beginning of retirement and adjust that for inflation every year, then you should not run out of money over a 30 year period.

When William Bennegan, or old Billy, put this together, there was actually, he said, a 100% chance over 30 years. However, a lot of things have changed. Market returns have changed.

Fixed income returns have changed. Lifespans have changed. All of these things have to be taken into consideration.

Now, quite often, when you're listening to someone talk about the 4% rule, they're often referring to that 4% rule in a confidence level of 90% to 95%. Some of the research we're going to look at today is a 90% certainty that you won't run out of money during retirement at certain withdrawal rates as you're adjusting for inflation each and every year. And to take that a step further, what we're saying is if you retire with a million dollars, at retirement, you take your first withdrawal of $40,000.

That's pre-tax. It's just a $40,000 distribution from your account. Whether it's pre-tax or after tax, you're taking 4%.

So 4% at $40,000, then the next year, you're adjusting it for inflation. And then you have to ask, what inflation rate am I going to use? Well, if you're using 3%, then the following year, you're going to be withdrawing 3% more, $41,200, and you're going to increase that every single year. Sometimes we misconstrue the 4% rule and say, well, we're going to adjust it for inflation every single year based on whatever inflation was in that given year.

That's not actually how this rule is tested and how it's actually put into practice. In addition, some people make the mistake of saying, well, I just take 4% out of my portfolio every given year, no matter what the value of that account is. So our distributions at 4% could be fluctuating quite a bit.

That million turns into $500,000, we take $20,000. That million turns into $2 million, we take $80,000. That is not what the 4% rule is.

That is not how it actually functions. And that's not how these scenarios are ran. And there's some things that are important for us to understand when we're trying to determine if the 4% rule is going to work for us, because there's assumptions being made.

That is the time horizon that you're going to be in retirement. It was originally on a 30 year time horizon, you may have a 20 year horizon, you may have a 40 year horizon, you have to determine how long you want that money to last in retirement. And then it's dependent on your allocation to fixed income bonds or stocks equities.

So how much we allocating equities, how much are we allocating to fixed income? What's the inflation rate that you're using? Are you using a historical inflation rate? Do you want to use a different inflation rate? That has to be determined as well. And then we have to determine what kind of returns we're going to apply to the fixed income and the stock portion. This is why ultimately you need to use this rule on the way to retirement.

Say when you get within 10 years of retirement, you need to start customizing that strategy for yourself and running simulations based on the way you're actually going to invest in retirement. Not too many people are investing in a 50-50 mix of stocks and bonds. And the way the analysis is often run, they're looking at historical returns of the S&P 500 or historical returns of treasury bonds.

Well, you may have corporate bonds, you may have municipal bonds, you may have longer term bonds, shorter term bonds, you may have different type of equity allocations. And most of that scenarios that you'll actually see when you're out on the internet, most of those scenarios were actually based on indice returns that you can't actually invest directly into. They're not accounting for any cost that you would have for investing in that particular index, which you will have cost no matter how you invest in the market.

So these are all the variables that need to be considered. And there were some numbers that were ran by Morningstar Research back in 2023 that'll help add a little bit of additional context. Let's take a look at those now.

This is a chart that kind of walks us through all those variables. Now, they're looking at a portfolio, a balanced portfolio of stocks and bonds. So you have a nice mix.

However, they're also varying that equity weighting or that stock weighting over here on what would be the Y-axis. Then on this X-axis, if you will, this horizontal bar at the top, these are the number of years that we want those assets to last throughout retirement. So if we say, hey, I'm only going to be in retirement for 10 years, which I've met with individuals that are in that situation where they're in very poor health, they're not going to be in retirement very long.

So maybe we want to use that 10-year period of time. If we're using that 10-year period of time, we can see those withdrawal rates for a 90% confidence interval to land somewhere between 8% and 10%. Now, another thing we have to really emphasize here is we're looking at a 90% degree of confidence.

Why is there a 90% degree of confidence? And are you comfortable with 90%? Because that means that one in 10 scenarios, you're running out of money before the end of that time period. And most people aren't very comfortable with one in 10 scenarios running out of money. They want a 95%, a 98%.

Of course, we would prefer we had an overfunded retirement and we have 100% chance certainty. Now, in what scenarios that are being ran, does that 10% chance of failure actually come into play? That almost entirely comes down to something known as sequence returns risk. The returns and the sequence that they actually occur for us throughout retirement.

That 10% chance of failure in most scenarios means that you experienced a bad period of time in the stock market, in the market in the first 10 years of your retirement. And that could be retiring as many did at the beginning of a financial crisis in 2008, or retiring at the end of the tech bubble and right before 9-11. And you experience a long period of time like we had at that point in our lives, the lost decade.

And now we're running out of money. If that occurs, what is the odds now that you're going to run out of money during retirement? It's probably closer to 100% that you're now running out of money in retirement. It's no longer 90% chance of success.

It might be a 90% chance of failure. So you want to start planning for those things very diligently in retirement. Now, if we go back to this chart and say, let's find that 4% withdrawal rate, we can come on over here.

There's two areas on this entire chart. For the most part, you're going to find this 4% withdrawal rate down here over a 30-year time horizon with a 40 to 20% equity allocation. If we look over a 30-year period and we said, we're going to go 100% equities, now the odds of success at 90% say that we can now safely withdraw 3.3%. Say that we can now withdraw 3.3% from that portfolio and have a 90% chance of success.

And it does seem that there's a bit of a sweet spot there over 30 years, having somewhere around a 40% or 20% equity allocation, the rest of fixed income. If we were to take that back just a little bit, let's say that we wanted our funds to last for 20 years, those withdrawal rates are landing somewhere between 4.6%, 5.5%. And there seems to be a pretty constant along all of these different numbers that that sweet spot is around that 20 to 40% equity allocation. Now, is that the right thing for you? I don't know if that's the right thing for you, because if you're five years out from retirement, we need to start running some scenarios that are based on your own unique circumstances.

And then we can stress test things running these Monte Carlo simulations where you're running 1,000 different scenarios every year over the time horizon you plan to be in retirement to see what percentage of those scenarios does it fail and what are your odds of not running out of money in retirement. To get one of those scenarios ran for yourself and to visit virtually or in person with one of our personal financial advisors, all you have to do is call the number on your screen. Now, we're going to continue this discussion as we jump into the second part of this four-part series where we're going to be discussing something known as the rule of 100.