Relying on the 4% rule to determine when you can retire could be a disaster. In this video, I'm going to tell you four issues with this common retirement rule of thumb and a better strategy that could help you retire sooner and create more income for yourself in retirement.

To illustrate this, we're going to look at an example of a couple, Michael and Jan, who are about to retire at age 62. But before we get into that, what is the 4% rule?

What is the 4% Rule?

It may be the most popular financial rule of thumb, but I think it's often misunderstood.

What the 4% rule says is that when you retire, you can withdraw 4% of your total portfolio balance in the first year of retirement and increase that number annually by inflation. And you can do that while feeling confident that you won't run out of money.

So our new retirees, Michael and Jan, have a $1 million portfolio. The 4% rule says that they could withdraw $40,000 from their investments in the first year and increase that $40,000 number each year by inflation.

So if inflation in that first year was 3%, then their portfolio withdrawals in year two would be $40,000 increased by 3% or $41,200. So in year two, their withdrawal rate could be more or less than 4% of the portfolio balance, depending on what their investment return was.

The 4% number is used solely to determine their withdrawals in that initial year.

4% Rule Flaw #1: Assumption of Constant Withdrawals

Now, the first major flaw with the 4% rule is the assumption that the portfolio withdrawals remain constant adjusted for inflation throughout your retirement.

This doesn't account for other income sources that may show up later in retirement, like social security. It also doesn't account for changing expenses.

Most retirees spend more in the early years of retirement while they're still physically able to, but less as they get into their late seventies and eighties. This could mean that you need to withdraw more from your portfolio early on, especially before social security benefits begin and then less later on. So a fixed dollar amount doesn't really make sense.

In Michael and Jan's case, they decide that they're going to take Jan's social security at age 62 when they retire. And her benefit's going to be $1,500 per month. Michael is going to wait to claim his benefit at age 70 when it will be worth $3,000 per month.

If we look at the retirement income picture, they're going to have the $40,000 of portfolio withdrawals, which comes out to $3,333 per month, plus $1,500 per month from Jan's social security for a total of $4,833 per month. And that's going to be their standard of living for the first eight years of retirement.

Then they'll get a big pay bump from Michael's social security at age 70. And their total monthly income would be $7,833 per month.

So looking at this, we can already see it makes no sense. It would be much better if their retirement income was smoothed out over time.

4% Rule Flaw #2: Sequence Risk

Another significant issue with the 4% rule is what's known as sequence of returns risk.

The idea here is that the order in which you receive investment returns can drastically impact your sustainable retirement income. Negative portfolio returns early in retirement can deplete your portfolio really quickly because not only are you losing value from your investments, but you're also withdrawing from the portfolio to provide that retirement income.

If, instead, you have good or even average returns early on, then your portfolio builds a cushion beyond those portfolio withdrawals in order to absorb future negative returns. So strong early returns can enhance your financial stability significantly.

Let's look at an example. This is showing us a $1 million portfolio invested in 40% stocks, 60% bonds for an investor retiring at age 65 in 1966.

They're following the 4% rule, so we would assume they'll be fine. And with the benefit of hindsight, we know that a 40% stock, 60% bond portfolio had an annual return of 9.5% from 1966 to 2000.

So they should definitely be fine, right? But what happened? They ran out of money before age 90.

How did that happen? Because the returns in the first several years after retiring were not good. And inflation in the 1970s was high.

There were some great years in the 80s and 90s, but by that time, their portfolio was so depleted that those good returns couldn't make up for the withdrawals in the poor market return years. So the 4% rule doesn't leave room to adjust for this risk, but at the end of this video, I'll go over a better strategy that will give you more protection against sequence of returns risk.

4% Rule Flaw #3: Based on Worst-Case Scenarios

The third problem with the 4% rule is that it's based on worst case scenarios. Now we just looked at one, so basing withdrawals on a worst case scenario may not sound like a bad idea.

However, most of the time you're not living through a worst case scenario. And so most of the time the 4% rule is going to be too conservative and causes many retirees to die with more money than they started retirement with.

This may sound like a good problem to have, and it's definitely better than the opposite end of the spectrum: running out of money.

But it means that many retirees could have used more of their money while they were alive. They could have traveled more, helped out their kids more, or been more generous to the charities they support during their lifetime, potentially increasing the quality of their life.

So we should strive to incorporate a strategy that allows us to make the most of our money while we're still living.

4% Rule Flaw #4: Differing Retirement Lengths

The final issue with the 4% rule is it's based on a specific retirement length, which may not be your retirement length.

The original studies assumed a 30-year retirement, but not everybody's going to fit in that box. Somebody retiring in their 50s should plan on a longer retirement, so 4% could be too aggressive.

On the other end, somebody working into their 70s may be able to safely spend more than 4%.

Differing life expectancies and retirement ages require adaptable strategies, not a one size fits all approach, which leads me into the better solution.

A Better Approach To Retirement Withdrawals

In light of these issues we've discussed (changing income needs from the portfolio and retirement, sequence of returns risk, leaving too much money unspent, which could have enhanced the quality of your retirement, and differing retirement time horizons), a different strategy is going to be one that can be flexible and solve these issues better than the 4% rule.

The strategy that we use with clients that fits the bill is a dynamic income strategy with guardrails. Let me explain how this works.

A guardrail strategy is going to look at your likely retirement time horizon and changing income needs in your retirement years and determine an initial income level that the portfolio can support. Then you place guardrails around the portfolio balance, which tell you when you can increase your spending or when you need to cut it back.

If portfolio returns are good, you can bump up your spending and lessen the chance you leave too much money on the table. If returns in those initial retirement years are bad and we experience that sequence risk, then we can cut back on spending to let the portfolio recover before increasing spending again.

Example of a Dynamic Income Strategy With Guardrails

To illustrate this strategy, let's go back to Michael and Jan.

We already showed how the 4% rule would create a nonsensical retirement income. Well, if Michael and Jan were instead using a dynamic income strategy with guardrails, what would that look like?

Instead of retirement income in those first eight years of $4,833 per month, when we smooth out their income, we might say they could spend more like $6,500 per month. That's a substantial increase in standard of living.

Then we could put guardrails around their portfolio balance and we'd say if your portfolio increases to $1.076 million, then you can increase your spending to $7,000 per month. But if your portfolio decreases to $725,000, then we need to cut back your monthly spending back to let's say $6,200 per month.

The way we determine what the initial retirement income is and where those guardrails are at will depend on a lot of factors like Michael and Jan's risk tolerance and how flexible their expenses in retirement are.

If they're very flexible and don't mind adjusting their spending with market returns, then maybe we increase that initial spending level a little bit and make the guardrails a little bit tighter.

If instead they want a more predictable income, then we could set that initial income lower and make the guardrails wider.

The point is, using a dynamic income strategy with guardrails in retirement addresses the limitations of the 4% rule and can lead to a better overall retirement experience.

As always, this video is intended for a general audience and should not be considered financial advice for any individual. If you need help crafting a retirement plan, then I'd encourage you to reach out because we can help. Schedule a free consultation below.