Rethinking the 4% rule

One of the best known strategies to avoid running out of money in retirement is the 4% rule: Every year you take 4% of the portfolio's initial value, adjusted for inflation, and have a reasonable expectation that your assets will last. That plan has one serious flaw, though. We are living longer than ever.

This is good news, but it means that we may have to depend longer on a savings portfolio to finance our retirement. The risk of outliving our portfolio is real. Our success depends on choosing the right investment and spending strategy so our savings don't run out after we no longer draw a salary.

The 4% rule does not say whether 4% of your portfolio is barely enough to heat your house or plenty to pay for leisure travel. It only tells you how much you can take without running your well dry. This is a problematic rule, partly because it’s potentially inefficient and rarely adequate, but also because of its popularity.

The Nobel Prize winner in economics, William F. Sharpe, calls it the “the most endorsed, publicized and parroted piece of advice that a retiree is likely to hear.” The basic problem with this rule is that it suggests a fixed annual spending schedule can be supported by a volatile investment climate. The way we approach this mismatch can make a big difference between failure and success.

A companion to this rule: A 60%/40% mix of stocks and bonds will give the average retiree a good chance of success. All sorts of historical data show how stocks zig while bonds zag. But this asset allocation is laden with hidden, undisclosed risks. One is the “sequence” risk: historical returns, volatilities and correlations do not account for the huge difference that a few good or bad years at the beginning of retirement can make.

A market that doubles and then drifts down to its initial value at the end of 20 years is far better than one that falls by 50% at the start and then recovers to the same value. During these two decades, you are withdrawing money to live on. So the sequence of returns matters a lot.

Another problem: While an aggressive allocation (that is, heavy in stocks) can boost the value of your portfolio for a while, it also increases the chances that you will deplete your money.

To see why, imagine that, on your way to a movie theater, someone offers you to play a game. For $10, the price of the movie ticket, you can flip a coin and receive $30 on heads and nothing on tails. The average outcome of this game is $15 (half a chance of $30, plus half a chance of $0). This sounds like a great deal.

But you go from being able to pay for the movie ticket to having a 50% chance of being unable to. Your expected wealth went from $10 to $15, but your risk has gone up too. This highlights the importance of not losing sight of your goals. All you want to do is buy a $10 movie ticket. Gambling that certainty to increase your wealth to $30, even though the expected value of this gamble is exceedingly favorable, has nothing to do with your original goal – watch the movie.

Even if you win, you will just buy the $10 ticket and have an extra $20 bill that serves no purpose. Why gamble it?

Gambling with your portfolio

An equivalent example: Imagine that you have saved enough to support your retirement spending needs with a portfolio invested in U.S. Treasury bills. However, your brother–in–law convinces you that you can boost your returns with a 60%/40% mix of stocks and bonds. Given historical returns, this should give you, on average, a higher value at the end. But you are also gambling your retirement.

While it is reasonable to expect that in the end your portfolio will be larger, your real goal is to have enough to pay for your lifestyle. Assuming that you have no bequest motive, gambling in order to pad your portfolio needlessly increases your chances of ruin. Making this mistake is easy.

Intuitively, it seems to make sense that choosing an investment with a higher expected return than U.S. Treasury bills – like stocks – is a good thing: You want to build an extra cushion, just in case you need one. Some academic work defines people as “rational” insofar as they always prefer more wealth to less. But higher potential wealth without a purpose, subject to more risk, is not directly comparable with less wealth that satisfies a defined goal with less risk.

Those are some of the dangers of investing when you don't know why you are investing. Your financial advisor can help you avoid some of these dangers.