Revisiting the 4% Rule

Rules of thumb are popular financial decision-making tools. But they can lead to negative outcomes because they are a heuristic. A heuristic is a mental shortcut that people use to make decisions using limited time, mental resources and information. It is much easier to use a rule of thumb than to apply the time and energy for a thorough and objective analysis.

There are many rules of thumb in personal finance. Given the importance of financial decisions on the quality of life, the degree to which people rely on these mental shortcuts should be surprising. However, the power of heuristics on human behavior suggests that this human frailty is baked into our mental processes and significant self-awareness is required to overcome it.

The origins of the 4% rule

The rule was established in the early 1990s using historical data on stock and bond returns over the 50-year period from 1926 to 1976. (see chart on page 17) It was a rate established to help retirees determine a portfolio withdrawal rate (indexed to inflation) that would result in their portfolio lasting until the end of life (not being fully depleted prior to death.) It is important to note that prior to the early 1990s, experts considered 5% to be the safe withdrawal rate, which suggests that the 4% rule was not immutable.

Why the 4% rule is problematic

- We are living longer

According to Statistics Canada, in 1991, men aged 65 had a life expectancy of 80.6 and women aged 65 had a life expectancy of 84.7. The latest data from 2012 shows that men aged 65 are expected to live to age 84.2 and women to age 87. Remember, these are averages, so unfortunately, many will not reach these ages, but many will outlive them. As of 2012, five out of ten Canadians aged 20 are expected to reach age 100.

The longer we live, the lower the withdrawal rate needs to be. On this basis alone, the 4% rule is outdated and overstated.

- Interest rates are low

As you can see from the chart below, the 4% withdrawal rate worked regardless of asset mix. Even a 100% bond portfolio ensured sufficient capital up to 30 years. However, following the high inflation periods of the 1980s, the Canadian and U.S. governments’ monetary policy has been designed to keep inflation and interest rates low. You can see the steady yield decline of long-term Canadian Bonds in this chart.

This means that for the 4% rule to work, a significant weighting in equities is necessary. As people age, they naturally get more conservative and are less comfortable owning the investments that make the 4% rule work.

- It doesn’t consider your personal needs

The 4% rule has nothing to do with your cashflow needs in retirement, or the estate legacy you may want to leave. It doesn’t consider taxation, and as you know, withdrawing 4% from a fully taxable Registered Retirement Income Fund (RRIF) portfolio is very different from withdrawing 4% from a Tax-free Savings Account (TFSA) or non-registered portfolio. We spend after-tax dollars not pre-tax dollars, so 4% withdrawn from a RRIF can provide much less spending power than the same amount drawn from other investment sources.

- You don’t need a new short-cut

It’s tempting to try and solve this problem with a new, lower, withdrawal rate. But that’s just another shortcut, and your retirement planning deserves better.

You may not like the solution, though, because it requires the opposite of a shortcut. The right answer for any individual is a detailed analysis that considers: taxation, your personal cashflow needs including irregular needs (home updates, car replacements, special vacations, gifts to children, health care etc,) your real estate equity, your pension income sources, your personal expected mortality, your investment risk tolerance and your whether or not you want to leave a financial legacy.

But it doesn’t stop there. Given the long-term nature of the analysis, you need to track your progress and adjust accordingly. If returns are higher than expected, or taxes lower, it would be a shame to find out 20 years later that you could have spent more. Conversely, if your spending is higher than expected, or returns lower, better to address the challenge immediately than after your savings have run out.

Anyone who suggests there is an easier way is simply taking a short-cut.

This information is of a general nature and should not be considered professional advice. Its accuracy or completeness is not guaranteed and Queensbury Strategies Inc. assumes no responsibility or liability.

Rona Birenbaum CFP, founder of Caring for Clients, one of Canada’s premier financial planning firms.