Why You Should Not Use The 4% Withdrawal Rule & What To Use Instead

In this episode of Your Retirement Guide, George Jameson, CFP® and founder of Capital Wealth Group, explains why you shouldn't be using the 4% withdrawal rule in retirement and what you may want to use instead. 

 Welcome to "The Retirement Guide" Podcast! I'm your host George Jameson, owner of Capital Wealth Group, a Fee Only Advisory firm. Whether you’re nearing retirement or already retired, Join me each week as we explore the world of retirement planning and equip you with the knowledge and tools you need for a successful retirement.

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This is for education only.It is not tax, legal, or investment advice. Before  acting on any information consult your tax, legal, or investment advisor.

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Transcript

George Jameson: 0:18

I am George Jameson, certified financial planner and founder of Capital Wealth Group, located in Columbia, South Carolina. So let's get started. Today we're tackling a popular yet increasingly controversial topic in retirement planning. The 4% withdrawal rule. For decades, it's been touted as a safe, simple way to ensure your savings last throughout retirement. You simply add up your retirement savings, withdraw 4% during your first year of retirement, adjust that dollar amount for inflation each year after, and you shouldn't run out of money for at least 30 years. It's very straightforward and easy to follow. And I still believe it's a good place to start to see if you're on track for retirement. However, relying on this rule as your sole strategy can be a significant gamble. Why should you avoid it? We don't know what the future holds, and at best, it could cause you to unnecessarily constrain your lifestyle or at worst, lead you to depleting your assets prematurely. So what are the core problems with the 4% rule in today's environment? First, let's talk about expected future returns. Many economists and financial institutions are now projecting lower returns for both stocks and bonds over the next decade or two compared to historical averages. When your portfolio is growing at a slower pace, withdrawing a fixed 4% may be fine, but when that amount is also increasing with inflation, it puts a much greater strain on your principle. Think of it like drawing water from a well, that's not being replenished as quickly as it used to be. Eventually it runs dry. If future returns are indeed lower, a 4% withdrawal rate might be more like a 5% or 6% effective rate in terms of portfolio depletion, dramatically increasing the risk of running outta money. Second sequence of returns risk. I've talked about this risk before, but it's very important. This is a critical concept that the 4% rule does not adequately address. It's not just about average returns over 30 years when you're taking money out each year. It's about when those returns occur. If you retire and immediately face a significant market downturn, say a 20 or 30% prolonged drop in your portfolio value, withdrawing, 4% of your initial balance, plus you add inflation adjustments means you're selling more shares when prices are low. This creates permanent losses and severely hampers your portfolio's ability to recover and grow. When the market eventually bounces back, the first few years of retirement are crucial. And a bad sequence of returns early on can cripple a portfolio even if long-term average returns are decent. The 4% rules fixed nature. Makes it vulnerable to the sequence of returns risk. And then third is longevity risk. People are living longer and your retirement may last longer than 30 years. If you retired at age 65, that takes you to age 95. But what if you retired at age 60 or 62, which a lot of my clients do. Or what if you or your spouse live well into your late nineties or even past 100? A plan designed for 30 years may not be sufficient for a 35, 40, or even 45 year retirement. And then fourth inflation variability. The standard 4% rule application involves adjusting the initial withdrawal amount by the rate of inflation each year. The original study did account for historical inflation. However, we've recently seen inflation behave in ways many haven't experienced in their adult lives. While the rule tries to account for this a period of sustained high inflation, especially if coupled with low market returns like stagflation can rapidly erode the purchasing power over your withdrawals and accelerate the portfolio depletion. And then fifth, the 4% rule is a one size fits all approach in a world that demands personalization, it doesn't consider your specific financial situation, your unique retirement goals, your risk tolerance. Your other potential income sources like pensions or part-time work, or your healthcare expenses, which can rise greatly later in retirement. Are you planning on leaving a legacy? Do you have significant healthcare concerns? Are your spending needs likely to decrease later in retirement or increase due to travel and adventure early on in retirement? The 4% rule offers no flexibility for these very personal, very real considerations. It's a blunt instrument in a situation that calls for surgical precision. So if the 4% rule is not for you. What are some alternatives? Well, it's not about finding another magic number. It's about adopting a more dynamic, flexible, and personalized approach to retirement income planning. This may involve variable or dynamic withdrawal strategies. These strategies adjust withdrawal amounts based on portfolio performance. For example, you may take out less after a down market year or slightly more after a strong market year. These are often called guardrail strategies. Guardrail strategies, for instance, set upper and lower bounds or bands for your withdrawal rate. If your portfolio does exceptionally well, you may take out a bit more. If it does poorly, you tighten your belt. Go check out my episodes on the guardrails and dynamic withdrawal strategies. The next approach you could consider would be a bucket strategy. I prefer the two bucket strategy. If you want to learn more about the two bucket strategy, I have at least two episodes on this as well. This involves segmenting your assets into two buckets. Bucket one would be your short term needs, let's say one to three years. It's usually invested in safe assets like money, market funds and treasuries and so on. And then bucket two is your mid and long-term needs. This bucket holds your stock and bond mix like a 60 40 investment portfolio or whatever allocation fits your needs, risk tolerance, et cetera. Another option you could use is called Stress Testing. This is where you're using sophisticated financial planning software like the one I use for my client to Right Capital. We can model various withdrawal strategies in various scenarios, like poor market returns, high inflation, longer life expectancy, different spending patterns, and so on, to see how your plan holds up in these scenarios. And finally, I suggest no matter what strategy you use to do regular reviews and adjustments, retirement isn't usually a sit it and forget it affair. Your plan needs to be reviewed regularly, at least annually or when major life events occur, and then adjust it as needed. The bottom line is that while the 4% rule is a valuable starting point for discussion. and provides a useful historical benchmark. Its simplicity is its greatest weakness in a complex financial world. Relying solely on it is like navigating a modern superhighway using a map from the seventies. You might eventually get to your destination, but you're just as likely to get lost or find that the roads you are counting on no longer exist. Your retirement is too important to leave to an outdated rule of thumb, it requires a tailored plan, one that reflects your unique circumstances. Adapts to changing market conditions and is stress tested for resilience. That's it for today. Happy planning and have a great day.