Why a bespoke plan could be considered instead
The problems with the 4% rule - and why a bespoke plan could be considered instead
The “4% Rule” within financial planning circles usually refers to the idea that you can safely take 4% out of your pension each year to live comfortably and sustainably. It has been popular since at least the 1990s when it was conceived, but has gained more attention in recent years due to rising young YouTube stars in the modern FIRE movement (i.e. financial independence; retire early).
Certainly, one of the attractions of the 4% is that it refines a complex problem - i.e. how to ensure you have enough money in retirement - down to a simple rule which is easy for people to understand.
However, as financial planners our role is to bring working solutions to our clients, not just those which are easy to grasp. Whilst the 4% Rule holds certain strengths and might still be suitable for specific situations and financial goals, this article highlights why it presents large problems in many cases which should lead individuals to consider crafting their own bespoke retirement plan rather than relying on a universal rule.
Human beings seem to naturally be attracted to simple-sounding solutions to difficult issues. Politics is rife with examples. One might arguably point to the right, - such as President Trump’s policy to “build a wall” to solve illegal immigration from Mexico - or to the left - such as Labour’s proposal to re-nationalise certain industries in the 2019 general election (although admittedly proponents would argue such solutions were unfeasible).
Similarly, people can be quickly drawn to quick, easy-sounding solutions to difficult financial problems which later land them in trouble. Indeed, this is arguably why many people fall for pension scams - such as promises by a cold caller that he/she can help you access your pot before the age of 55.
The 4% is certainly not maliciously intended, and it gains further power due to its academic underpinning. In 1994, US financial planner William Bengen put forth the idea in a paper using historical simulations. Taking stock and bond data in the US over a 5-year period, Bengen concluded that a “Safe Withdrawal Rate” from a typical retirement portfolio was 4% and that this should enable most people to live on their retirement savings and investments for a 30-year period. The idea was neat, attractive and quickly caught attention - living on to this day in 2020.
As is often the case in history, popular ideas can be shown to be lacking when individuals have the boldness to challenge their central claims. For the 4% Rule, this happened when Wade Pfau tried to apply Bengen’s research to a wider context to see if the Safe Withdrawal Rate applied in other countries and markets. He collated 109 years of financial market data (1900-2008) and looked at 17 developed market economies using domestic currencies and asset classes. The results were interesting. Pfau concluded that, in the UK, even with the best foresight and “perfect blend” of bonds and equities, a maximum Safe Withdrawal Rate could be placed at 3.77%. Only if the client accepted a 10% likelihood of “failure” (i.e. running out of money in retirement) did the percentage rise to 4.17%. The failure rate then skyrocketed to 27.5% when the withdrawal rate was raised to 5%.
The picture becomes even more bleak when you consider that Pfau’s study didn’t factor in the impact of fees or fund charges which anyone looking to take an income from their pension savings will have to consider.
If people can’t rely on the 4% Rule, then is there another rule which might suit better - maybe at a lower Safe Withdrawal Rate?
Certainly, the Financial Conduct Authority sees value in offering such “rules of thumb” to assist UK consumers in their decision-making - setting up the Financial Advice Working Group in 2019 for this very purpose. Taking this into account along with the reality that each client’s situation and goals are unique, here is one alternative to consider for those looking to retire early:
Higher equity weights within a retirement portfolio (i.e. a more aggressive stock allocation) might allow for more sustainable income over a 30+ year retirement period. However, such individuals looking at a longer retirement horizon should seek professional financial advice to ensure they understand the higher risks involved with a 60%, 70% or higher equity weight.
One of the central issues to consider here is the fact that people are living longer. Bengen’s 4% was developed in the 1990s when life expectancy for men and women was lower, and also the period of study (i.e. 1900-2008) concerned lower expectancy still. In 2020, an individual might be facing a 40+ year retirement or longer, rather than the 30 years covered in his study where a 50-50 split between stocks and bonds was used in the portfolios for the simulation.
In short, we can probably safely say that: