Retirement Income Strategies: How to Improve on the 4% Rule

In the past few years, the 4% rule has been challenged by those who claim its premise of 4% inflation-adjusted withdrawals is too optimistic under today’s market conditions. Others assert that more sophisticated approaches will yield better-than-4% results. I'll evaluate two alternatives – economic utility maximization and required minimum distributions (RMDs) – and also discuss the practical implications for advisors.

Advisors face a confusing array of choices in deciding how to advise clients about using savings to generate retirement income. In this blog post, retirement researcher Wade Pfau developed a chart displaying 34 different strategies for managing retirement income, and the list continues to grow. Evaluating all these choices would require a Piketty-length book.

I'll compare the 4% rule to two other approaches that have particular relevance for advisors. I'll also discuss variations on these strategies.

The 4% rule

The 4% rule was developed by financial planner William Bengen and described in his article “Determining Withdrawal Rates Using Historical Data” in the October 1994 issue of the Journal of Financial Planning. This is arguably the most famous article ever written about financial planning. Bengen's primary goal was to demonstrate that a safe retirement withdrawal rate was significantly less than one might assume based on historical average returns for stocks and bonds. He based the analysis on a withdrawal rate established at retirement as a percentage of savings, with the dollar amount of withdrawals increasing each year by the inflation rate.

In recent years, the 4% rule has been criticized as too aggressive given current low bond yields and lower return prospects for stocks, such as in this article by Michael Finke, Wade Pfau and David Blanchett. The rule has also been criticized as too inflexible, unaware of individual risk preferences and incapable of adapting to realized investment performance. Examples of such criticisms are “The 4% Rule – At What Price?” by Jason Scott, William Sharpe and John Watson and “Spending Retirement on Planet Vulcan: The Impact of Longevity Risk Aversion on Optimal Withdrawal Rates“ by Moshe Milevsky and Huaxiong Huang.

Such criticism has given rise to the growing number of proposed alternatives.