A Safer Four Percent Withdrawal Rule
Robert Huebscher
March 24, 2009

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Financial planners cite few principles as often as the “4% rule.”  Originally developed by William Bengen in 1994, it argues that investors can safely withdraw 4% from a retiree's balanced stock/bond portfolio in the first year, and then adjust that dollar amount upward each year for inflation.  This withdrawal rate has proven to be sustainable over every 30-year period since 1926, sometimes just barely, sometimes leaving the heirs with many millions of additional dollars.

Under current market conditions, however, investors can adopt a superior approach.

By constructing a portfolio consisting of municipal bonds and Treasury Inflation Protected Securities (TIPS), an investor can sustain a 5.60% withdrawal rate if current inflation rates (2.0%) persist over 30 years.  A less aggressive 4% withdrawal rate would be necessary only if inflation averaged 7.09% over this period, more than twice the average inflation rate over the past quarter century.


Bengen approached the problem of determining the safe withdrawal rate from an equity-centric perspective – he used bonds to fill in whatever portion of the portfolio was not invested in stocks. He studied portfolio mixes ranging from 50% to 75% stocks, and concluded that such portfolios “should be safe” for investors making year-end inflation-adjusted withdrawals.  The starting withdrawal amount is equal to 4% of the initial portfolio balance.  Bengen recommended an equity allocation “as close to 75% as possible” based on historical data going back to 1926.

Subsequent research suggested the sweet spot is closer to 60% in equities.  The research varies, but the general consensus seems to be somewhere between 40% and 75%, depending on the data set and some of the underlying assumptions.

In 1998, Cooley, Hubbard, and Waltz quantified Bengen’s definition of “safe,” reporting a 95% success rate for a 50/50 portfolio. 

In a 2008 paper, Nobel laureate William Sharpe and two co-authors noted that several major fund companies (e.g., Vanguard, Fidelity, and Schwab) advocate the 4% rule, citing success rates between 85% and 90%.  These fund companies offer equity-oriented mutual funds to support this investing discipline.

Michael Kitces, publisher of The Kitces Report, showed in a 2008 study that safe withdrawal rates in a balanced portfolio depend on market levels.  Using S&P 500 P/E ratios calculated with earnings based on 10-year moving averages, he showed that withdrawal rates in excess of 4% are possible when valuations are depressed.  The 10-year moving average, popularized by Yale professor Robert Shiller, smoothes earnings over business cycles.

The market’s current 10-year moving P/E ratio is 12.03, which, according to Kitces, indicates the market currently straddles the line between “fairly valued” and “undervalued.”  Using Kitces’ guidelines, retirement investors could adopt a “safe” withdrawal rate of 5.0%.

The methods examined in these studies share several important features with Bengen’s original, equity-centric approach:

Researchers have shown that the “average” successful withdrawal rate for a traditional portfolio is approximately 6.5%, but a more conservative 4% rate is necessary to survive the worst adverse conditions, based on historical data.  Nonetheless, if those adverse conditions occur at the beginning of the retirement period, and they exceed historical norms, the retiree is still left without options.

An all-bond portfolio, based on current market conditions, offers retirees far more certainty of success, and depends only on forecasted inflation rates.  Moreover, an all-bond portfolio is less sensitive to the timing of returns; in fact, only the timing of inflation matters.  Inflation is far more predictable than equity market returns and can be efficiently hedged using TIPS. 

The all-bond portfolio is insulated from the risk of historically unprecedented adverse market conditions near the beginning of the retirement period.  The risk of failure in the all-bond portfolio – which arises solely from underestimating the rate of inflation – occurs later in the retirement period, not at the beginning.  As in the traditional portfolio, retirees have time to adjust allocations or spending habits before principal is depleted.  But adjustments to the all-bond portfolio will be less severe, since the possibility of losses due to extreme market movements is eliminated.
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