The Four Percent Rule and Your Personal Pucker Factor


If you're an investor counting on the 4% Safe Withdrawal Rate for your retirement planning, your pucker factor should be going up to about an eight right now.

I first heard of the "Four Percent Safe Withdrawal Rate" via Mr. Money Mustache. It states that if you draw down your investments by 4% each year (withdrawing the money to live on) there's a high degree of confidence your investments should last for a 30-year-retirement. Assuming you have enough assets to support a 4% withdrawal rate, this has been a hugely comforting plan. It's made many people think they could retire sooner than their intuitions told them.

Here's the back-story on the rule: William Bengen wrote a paper in 1994 answering a seemingly simple question: "A new retiree makes plans for withdrawing some inflation-adjusted amount from their savings at the end of each year for a 30-year retirement period. What is the highest withdrawal amount as a percentage of retirement date assets that with inflation adjustments will be sustainable for the full 30 years?" I took this question from Wade Pfau's excellent analysis and expansion of Bengen's original paper. Bengen studied every 30 year period between 1926 and 1994, assumed a 50/50 stock/bond split1, and saw what the safest maximum withdrawal rate (SAFEMAX) was. During all those 30-year periods, the lowest the safe maximum ever became was 4.15%, and thus the 4% safe withdrawal rule was born. 2

Now as we all know, you can't guarantee future performance based on past experience. Just because the 4% rule worked for every 30-year period in the past doesn't mean it will work in the next 30 years. And there's been some evidence lately casting doubt on the 4% rule. The first bit of evidence we'll cover is the lower expected returns we're seeing from the market, and the second is changing macroeconomic conditions in the country as a whole.

The 4% Rule vs. Low Returns

During the time period used to test the 4% rule, the long-term return on a mixed stock and bond portfolio was around 7%. In Chapter 3 of Bernstein's "Investor's Manifesto," we talked about estimating the return of bonds and estimating the return of stocks. Bonds have a current expected real-money return of between -0.73% and -4.73%. The S&P 500 has a current real money expected return of 3.4%.

As you can see, this is considerably more gloomy than 7%. (Of course, we have no idea how long into the future these low returns will extend. Economic conditions could change and these returns could improve significantly. Or get worse. That's the tricky thing about the future.)

Now Wade Pfau, along with Michael Finke and David Blanchett, have completed a new analysis titled, "The 4% Rule is Not Safe in a Low-Yield World." Pfau has a more-readable explanation of the paper up on his blog.

He's re-run the analysis using current figures, and it isn't pretty. Using historical bond returns (the same ones used in Bengen's original paper), 6% of the time periods are problematic for investors using the 4% rule. Using bond returns of 0%, 33% of the periods are problematic. And using real bond returns of -1.4%, 57% of the scenario periods are problematic. Remember, our current estimated returns on bonds are in the range of -0.73% and -4.73%, which means that your odds of succeeding with a 4% safe withdrawal rate are probably less than 50-50.

The 4% Rule vs. Macroeconomic Conditions

Making predictions about the stock market is a fool's game. Most forecasters are roughly as accurate as the guys who predicted the 2012 Mayan Apocalypse. Still, when two experts I very much respect have good things to say about a forecaster, I'll listen.

John C. Bogle (the inventor of the Index Fund and founder of Vanguard), said in 2010, "One of the most accurate—and candid!—has been Jeremy Grantham, who is currently expecting a real return on U.S. equities of 3.5 percent over the next seven years, presumably equivalent to a nominal return of about 6.5 percent before inflation is taken into account." 3

William J. Bernstein, author of "Investor's Manifesto," "The Four Pillars of Investing," and "The Intelligent Asset Allocator," said, "The wise investor ignores the economy (macrobabble), market sentiment (animal spirits), and especially investment company strategists (astrologers, except I wouldn’t want to insult astrologers). I make one teensie exception: Jeremy Grantham, one of the few folks who arrives at expected asset-class returns the right way—by looking at current valuations laced with realistic analyses of per-share growth metrics, viewed on a background of historical pricing.4"

In Jeremy Grantham's November 2012 essay, "On the Road to Zero Growth5," Mr. Grantham forecasts that GDP growth for the US is going to be about 1.4% a year, or 0.9% adjusted for inflation. (Specifically, he forecasts 0.9% a year through 2030, decreasing to 0.4% from 2030 to 2050.) This is in contrast with the greater than 3% growth rate we've had for more than 100 years.6

Grantham outlines a number of reasons for this:

  • Population growth in the US peaked at 1.5% a year in the 1970s. Today it is closer to 0.5%, and after adjusting for fewer hours worked per person, man-hours worked annually are likely to go up at only 0.2% a year.
  • Growth in productivity won't help us, either in manufacturing (growing nicely but too small a percentage of our economy) or services (not growing at all).
  • Rising resource costs as it gets more expensive to extract oil
  • Costs associated with climate change, mainly food prices and flood damage.

As we saw in our Chapter 4 review of "Investor's Manifesto," success in investing does not necessarily track with the economic success of a country. China had a marvelous 20 years judging by GDP, but investors in the Chinese stock market lost money over the same period. Having the US economy in the doldrums does not necessarily mean investors will take a bath.

So there are examples of countries where the economy in general has done poorly, but investors have done well. But there are also examples of countries where both have done poorly. Which will the US be? Ask me in 30 years.

The New Safe Rate of Withdrawal

So what is our new safe rate of withdrawal? It's impossible to say for sure without waiting 30 years. However, we can take some insight from the safe rate of withdrawal other countries have had in the past. The inimitable Mr. Phau has run the numbers, and they're grim. In 21 countries, using 30-year periods between 1900 and 1981, the safe rate of return ranged from 3.96% in the United States to 0.26% in Japan. The average was 2.61%. The lowest four countries, Germany, France, Italy, and Japan, all took major damage in World Wars I and II. Leaving them out, the average is 3.05%.

All the countries where the SAFEMAX is under 2% suffered greatly through wars and invasions. Were the United States to suffer this kind of trauma, your portfolio may be the least of your worries.7 I think the chances of the US losing a WWII-scale war in my lifetime are pretty slim.

A withdrawal rate of 2% would almost certainly be fine in most circumstances.

Of course, the safest thing to do is keep your withdrawals under the amount that your investments earn each year. That's the closest thing to a sure thing there is in finance, but it has the disadvantage of leaving all your money to your heirs. You may have more fun spending it down in your retirement.

  1. It actually works for anything between 35% stocks and 80% stocks.
  2. Mr. Pfau's expansion of Bengen's work gives a SAFEMAX of 4.04%.
  3. From Bogle's Common Sense on Mutual Funds.
  4. From Bernstein's Efficient Frontier article, "Coming' Around Again?"
  5. Available from the "Jeremy Grantham's Letters and Articles" section of the GMO website, but only after you register. Registration is free.
  6. Sadly, Grantham says he'll address the investment implications of this in his next quarterly letter. I'm far too eager to read his take on this to be happy waiting that long.
  7. On the other hand, under those circumstances a nest egg might be the difference between life and death.