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The Perplexing Fascination with the 4% Rule

David Lau
December 19. 2022

This year, as always, there has been a lot of discussion and study about the ubiquitous 4% Rule that many financial advisors employ as their clients’ primary retirement income strategy. Should it be higher? Should it be lower? What’s the effect of inflation? How about using guardrails and adjusted spending?

Those are perhaps interesting intellectual questions, but let me expose once and for all the fundamental issue with the 4% Rule – it’s silly.

Why? Consider the starting hypothesis for developing the 4% Rule and safe withdrawal rates: “Is it possible to have a financially safe retirement when you limit the tools you can use?” Why do we put such an importance on a question that no retiree is asking? There is nothing wrong with the 4% Rule as a rule of thumb for portfolio withdrawals. The problem is the widespread application of it as a retirement plan.

Let me draw a parallel to home building to illustrate the folly of the question. Imagine how a potential home buyer would react to this proposal from their builder:

“There are many proven benefits to concrete foundations but I don’t like them and don’t know how to lay one, so I use wood instead. I use the best wood, and I have a study that shows the wood should hold up over time, as long as there are no termites or rot and you don’t put too much weight on it. It will require constant maintenance but should last 30 years. In the wrong conditions during the first five years the entire house could become unstable and may require you to avoid some rooms and remove some of your furniture to reduce the weight the foundation needs to support. And after 30 years the home will almost certainly collapse. Oh, also, while living in the home you will have to constantly worry about the stability of the foundation.”

Now let’s apply an equivalent explanation to an investments-only 4% Rule in the context of a retirement planning discussion between a financial advisor and their client: “There are many proven benefits to using annuities as the foundation for a retirement plan, but I don’t like annuities and don’t know much about them, so I only use investments. I pick the best investments and there’s a study that shows if I manage them properly and there’s not a bear market early in your retirement, inflation doesn’t rise too much and you don’t have any unexpected expenses, your assets should last 30 years. If any of those bad things happen, we’re going to have to adjust your spending, perhaps drastically. If you live beyond our 30-year plan, you will almost certainly run out of money. Oh, and during your retirement you will constantly have worry about how market performance is affecting your investment foundation.”

Of course, this isn’t the way it is explained. The option of an annuity isn’t generally presented even though for decades economists like Moshe Milevsky, Wade Pfau, Bill Sharpe, Harold Evensky and others have documented the benefits of annuities to retirement plans, to the point that Michael Finke at The American College of Financial Services stated, “the value of annuities has been proven beyond dispute.” Through their structure, annuities manage risks and bring efficiencies to income that simply cannot be achieved through investments. The benefits of annuities to clients can be both economic and psychological—which should not be discounted. Because of their income efficiency, annuities should be considered for clients who are taking income for their portfolio.

There are many types of annuities with different structures and you should consider these carefully before putting a solution in place. Safe withdrawal strategies show it is possible to safely fund retirement while artificially limiting the tool set to investments alone. “Possible,” but not best and not certain. Perhaps possible is interesting, but best is what we should be striving for and be discussing with clients. And that discussion should include annuities. It’s time to retire the 4% Rule as a retirement plan.

David Lau is Founder and CEO of DPL Financial Partners in Louisville, KY.


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