Research Cautions against 4% Spending in Retirement Rule

June 18, 2010 ( - The “4% rule" - the most commonly offered advice for spending in retirement proffered by investment professionals - can ultimately be harmful to the interests of people who follow it, according to new research.

Researcher Nobel Laureate William Sharpe, STANCO 25 Professor of Finance, Emeritus, at the Stanford Graduate School of Business, says the suggestion that the retiree spend an inflation-adjusted 4% of his or her retirement assets each year, while keeping the balance of those assets in a portfolio that typically includes both stocks and bonds, might be a reasonable strategy in a world where stocks aren’t risky. The research suggests more problems with the rule as well.  

“If a retiree adopts a 4% rule, he will waste money by purchasing surpluses, will overpay for his spending distribution, and may be saddled with an inferior spending plan,” wrote Sharpe and colleagues Jason Scott, managing director of the Retiree Research Center at Financial Engines, and John Watson, a fellow at Financial Engines, Inc., according to a press release.  

Sharpe says what’s really wrong with the 4% plan is its insistence on fixed spending coupled with investing in a portfolio with variable returns. In the most obvious case, when a retiree’s portfolio underperforms, pulling money out at the same rate means he’ll run out of money at some point. Less obvious, though, is the consequence of better-than-expected returns.  

The researchers contend generating a surplus means that there’s money left over at the end, which is a waste. Not only is the surplus wasted, but also there’s additional waste on the front end because the retiree paid for investment surpluses he didn’t need.  

Planners who believe in the 4% rule often modify it, changing the amount to withdraw, the length of the plan, the portfolio mix, the rebalancing frequency, or the level of confidence that the money will last. “However, all these variations have a common theme—they attempt to finance a constant, nonvolatile spending plan using a risky, volatile investment strategy,” say the researchers.   

They suggest that rather than adopt a 4% plan with risky securities, the investor could instead invest in TIPS (treasury inflation protected securities), suggests Sharpe. The yield will be lower than that of equities in good stock market years, but TIPS deliver the most purchasing power without risk one can obtain.   

To generate more income, the retiree might choose to accept some level of risk as a tradeoff for higher earnings, but how much risk is he willing to tolerate? Sharpe says investment professionals need to find ways to help clients make a realistic assessment of their own risk tolerance.  

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