Unraveling Retirement Strategies: Constant-Dollar Spending (4% Rule)

Sustainable Withdrawal Rate (SWR) strategies are based on the work of William Bengen[1], whose research uncovered sequence of returns risk. The basis of the strategy is that there is a constant amount of spending from a stock and bond portfolio that would have been “safe” in 95% of historical 30-year periods of stock returns.

SWR had a colorful beginning. Peter Lynch of Magellan Fund fame posited that a retiree should be able to invest in stocks and spend about 7% of her portfolio forever. Scott Burns quickly showed that a 7% withdrawal rate was far riskier then Lynch imagined.[2]. (The culprit, as Bengen would show, is sequence of returns risk. The order of market losses is more important than the average return.)

Lynch’s response was, “OK, but surely there is some percentage that would work?”

Bengen found that the safe withdrawal percentage rate in the U.S. was historically 4% to 4.5% over rolling 30-year periods of market returns, hence the “4% rule."

Wade Pfau later showed that number only worked in the U.S. and a handful of other countries[5]. More recent work by Pfau suggests that the number at present is perhaps 3% to 3.5% — a sizable range. A range of 3% to 4.5% may sound small but it’s the difference between a safe spending amount of $30,000 and $45,000 a year per $1M of savings. Regardless, it’s well below Lynch’s 7% assertion.

The basic process for implementing this strategy is for a retiree to calculate 4% (or 3% or 4.5%, depending upon who you choose to believe — I'd go with Pfau) of her total investment portfolio value the day she retires and to spend that dollar amount (not percentage) for the rest of retirement, increasing it annually by inflation.

A retiree with a million dollar portfolio who agrees with Pfau's 3.5% could spend $35,000 the first year of retirement. If inflation ran 2% that year, he could spend $35,700 the following year.

This strategy will result in two possible outcomes when simulated, though actual retirees might not behave this way. The strategy will produce a constant, inflation-adjusted income amount from the portfolio until the retiree dies or the portfolio is depleted, whichever comes first. SWR practitioners try to minimize the latter outcome to “only 5% or 10%” of retirements, or 1-in-10 to 1-in-20.

With all due respect to Bengen, whose research exposed sequence risk — an important contribution — I consider this strategy irrational and believe that it probably makes sense only for households with so much savings that they don’t need it. The idea that we can spend an amount calculated at the beginning of retirement and continue spending it regardless of what happens to our financial situation over perhaps 30 years is not only risky but irrational.

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