Conventional financial planning uses two rules of thumb. One is the 70% replacement-rate, retirement-spending rule. The other is the 4% retirement-asset, spend-down rule. The replacement-rate rule says you need to accumulate enough assets to be able to spend 70% of your pre-retirement income in retirement. The 4% rule says you should withdraw and spend an amount equal to 4% of the retirement account balances you held when you first retired. Whether these two rules, both of which tell you what to spend in retirement, are mutually compatible is a good, but apparently never posed question to which I'll return in a subsequent column.
Today's article rubbishes, as the Brits say, the 4% rule. This article from last week rubbished the replacement rate rule. As it pointed out, the right replacement rate is based on the spending level that provides the household with the same living standard post-retirement as it enjoyed pre-retirement. The desire to have a stable lifestyle, i.e., to preserve our living standard, is what economists call consumption smoothing. It's why we save in the first place.
Given a household's current and future resources and the time pattern of those resources, one can solve for the precise spending path in all future years – pre- and post-retirement, which delivers the smoothest stable living-standard path subject to the household's year-specific cash constraints, i.e., subject to keeping the household out of debt or out of more debt.
My company's Smarter Personal Financial and Retirement Planning Software, MaxiFi Planner, makes this calculation. It's the only tool that does consumption smoothing subject to cash constraints. I developed it originally to do academic research, but saw early on that it could be used to provide households with personalized financial guidance. I and my colleagues have now spent a quarter century developing the tool. There is a single solution to the problem being solved. The tool finds it in a few seconds. But it took 25 years to sort out the algorithm and get all the critical details (e.g., federal and state taxes, Social Security benefits) right.
I point this out to make clear that there is no need to guess a client's or one's own replacement rate. One can figure it out quickly and precisely. In the prior article, I used the program to calculate the right annual spending for typical households and compare the implied replacement rates with 70%. The right rates were more often than not miles off from 70%.
But does using the wrong replacement rate matter? It sure does. Say you use 70% when the right figure is 80%. You'll be induced to significantly undersave. Alternatively, the right replacement case may be 60%, but you use 70%. In this case you'll be led to significantly oversave. Why "significantly?" Because being off by 10 percentage points for the roughly 35 years of your possible retirement means under-estimating or over-estimating cumulative retirement spending by a mile. This, in turn, will lead you to the wrong amounts each and every year before retirement.
Furthermore, even if a financial advisor were, by Divine providence, to come up with the right retirement-spending level (i.e., the right replacement rate), she would need to translate that into an annual pre-retirement spending and saving plan. But this requires the advisor to properly set the client's pre-retirement spending each year to keep the client's living standard stable in light of annual changes in income, housing costs, support of children, tuition payments, alimony, taxes, etc.
This isn't what planners do. Instead, they tell clients to save the same amount (or the same percentage of their incomes) each year straight through retirement. But this means their clients will experience a drop (rise) in their living standards when their incomes are temporarily low (high) or their off-the-top expenses are temporarily high (low).
This is the antithesis of consumption smoothing.
Ok, enough on the replacement rate. What about the 4% rule? According to Investopedia:
The 4 percent rule is a rule of thumb used to determine how much a retiree should withdraw from a retirement account each year. This rule seeks to provide a steady income stream to the retiree while also maintaining an account balance that keeps income flowing through retirement.
I've tried for years to wrap my brain around this "rule" and am still perplexed. Withdrawing a steady amount (adjusted for inflation) is a simple calculation one can make in Excel. You just need to specify start and stop dates and a rate of return. So "steady income stream" must really reference steady spending. In this case, the rule is focused on steady annual spending as a share of initial retirement assets.
To evaluate whether this ratio is anywhere close to 4%, I again used MaxiFi to consider a typical household. My pretend couple is age 66, married, has $500,000 in regular assets and $1 million each in retirement accounts. Their house is paid off, but their annual property, insurance and maintenance costs total $14,000. Each spouse just filed to collect a $2,500 monthly Social Security retirement benefit and each spouse just initiated annual smooth retirement account withdrawals. The couple earns 1% real on their regular assets and 2.5% real on their retirement accounts.
Let's call this couple the Saunders. What's the Saunders' proper spending rule? Is it 4% of their age-66 assets? No, it's 6.2%. If they have $2 million in regular assets it's 5.3%. If they have zero regular assets and $275,000 each in retirement accounts, their spending rule is 10.5%.
I could go on. The point is that spending rule is so extraordinarily sensitive to the household's precise situation as to be useless. And like the replacement-rate rule, choosing one's spending rule based on a rule of thumb is incredibly dangerous. It can lead households to either run out of money, suffering a severe decline in their living standard, or leave far too much money on the table when they pass away.
This is not 1950 or whenever these rules of thumb were first developed. We can do the math, we can solve the problem. We have the algorithms and high-speed computers. There is no reason to guess about what to spend this year or in the future. Using either the replacement-rate or 4% rules of thumb to manage your own or someone else's finances is akin to setting a tractor trailer on cruise control and taking a nap. That too is a rule of dumb.
Laurence Kotlikoff is a Boston University Economist, a NY Times Best Selling Author, President of maxifi.com, and Author of Money Magic.
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Hi George, Thanks for writing. The only way any such rule makes sense is if it's a share of the present value of net (of net taxes) remaining lifetime resources. But it's not. It's a share of assets -- regular plus retirement account assets. Since Social Security can be dramatically more or less important for people, not to mention other future resources and liabilities, like paying off a Parent loan for a child's education. Also, ever year's correct ratio of spending to assets will be different. The 4 percent rule is putting everything on autopilot and sleeping at the wheel. Bergen should just run MaxiFi and tell everyone to do the same. Why assume that everyone should follow the same rule? Yours, Larry
Really enjoyed this critique of the 4% retirement rule and the linkage to consumption smoothing - it resonates with the economics-based view that retirement strategies should be grounded in lifetime real consumption, not heuristics. I explored this idea further in a recent piece where I derive a closed-form savings rate under consumption-smoothing assumptions (including inflation, differential returns, and taxes) and provide an interactive calculator for it. If anyone is interested in a more analytical take, here’s the link: https://steadygrowthjournal.substack.com/p/how-much-should-you-really-save