Forget the 4% Rule: Retirement's Common Wisdom Is Obsolete

Get ready to play the retirement game even more cautiously: The common wisdom that a 4% annual withdrawal rate is the safe way to avoid outliving your money is increasingly coming under fire. In fact, it may well become a thing of the past.

The theory was simple: If you spent a maximum of 4% per year of your retirement funds, the decline in principle will be slow enough that your money would last as long as you did. Though the percentage seems modest and the reasoning sound, this 4% rule ignores two factors that have become increasingly, glaringly relevant: first, market volatility, which has battered retirement savings over the last decade, and second, inflation, the silent force that erodes purchasing power year after year.

Reverse Dollar Cost Averaging

Bill Bengen, a financial adviser in Southern California, created the 4% rule in 1994, demonstrating in a study that if retirees followed the plan, and increased their withdrawals over the years to adjust for inflation, their savings would last them for 30 years.

However, plenty of later research shows the 4% rule simply doesn't work in today's economy if the money is invested in a typical stock-bond mix, interest rates are low, and the individual in question is a reasonably healthy 65 year old, according to Dave Babbel, a professor emeritus at the University of Pennsylvania's Wharton School who specializes in investment strategies and asset/liability management.

One force that exacerbates the problem is "reverse dollar cost averaging," Babbel said. Traditional dollar cost averaging means investing equal amounts regularly into a portfolio. By doing so, the investor purchases more shares when prices are low, fewer when they're high, thus maximizing profits. It's a simple strategy that takes advantage of market volatility while accumulating assets.

But during the decumulation stage -- when pensioners are deriving their income from assets saved and drawing down their assets -- the effect can play out in reverse, Babbel said. When the value of a stock is lower, for example, you need to sell more shares to pay your bills, leaving you with even fewer shares positioned to benefit should the price rebound later.

This economic phenomenon makes it harder to protect your retirement assets. "The probabilities of savings not lasting as long as a life are simply too great for most risk averse people to tolerate," he said.

Retirement planning should always be individualized: Rules of thumb like the 4% withdrawal rate don't take into account variables in lifestyle, nor can they account for elements like market volatility and inflation.

Maybe Is a Four Letter Word

Uncertainty is the biggest threat of all when it comes to retirement.

"They say if you take out no more than 4% each year, you should be OK," said Pete D'Arruda, president of Capital Financial Advisory Group in Cary, N.C. "I don't like words like 'maybe,' or 'probably,' or 'should' or 'could.' Those are all bad words in retirement planning."

Studies based on the current economic climate say the number should be 3%, and even that may not be cautious enough. "That's not even a guarantee when you're taking money out for the 30 to 40 years of unemployment otherwise known as retirement," D'Arruda said.

And, says D'Arruda, when retirees are deciding which investments to sell to provide cash flow for everyday expenses, another common rule usually prevails.

"Murphy's Law triumphs in humans, and we naturally usually choose the wrong one to liquidate," he said.

There are any number of theories out there, and financial chatter flows in abundance, but to D'Arruda's mind, the sure thing is best in retirement. His conservative advice: Try CD laddering at 1%; fixed income annuities are better than the variable ones; get the fixed income annuities locked into your principle so you can't lose it. "Annuities -- there are more bad ones than good ones," D'Arruda said.

But whatever strategy you chose -- whether to risk more with the aim of generating more income in retirement, or play it a little more defensively -- approach the task as a realist, not a gambler.

Getting the Ball into the Retirement End Zone

The other issue with basing your retirement plan on simple rules is that it can lead to complacency. But the idea that you can "set it and forget it" and everything will be fine is a trap.

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"There are so many 'experts' telling people different things, that they're not going to have to worry," D'Arruda said. "A rule means something in writing, something enforceable. But in retirement planning, there's a fluctuating source. You can't take a guarantee."

Further, those seemingly foolproof strategies can be difficult to execute.

At crunch-time -- the 10 years before retirement that he dubs "the financial red zone" -- you have to be extra vigilant about your savings. "[When] you're close to goal line, you have to wrap the ball up with two hands," D'Arruda said. " Throwing a Hail Mary isn't going to work in retirement. The market is all over the place."

Ultimately, the watchword should be caution.

And if it's a thrill you want?

"Go to Vegas and have some excitement with money you can afford to lose," D'Arruda said.