Few ideas in retirement planning are as widely repeated as the “4% rule.” Accumulate $1 million and you can withdraw about $40,000 a year. Need $80,000? You need $2 million. Need $100,000? Better have $2.5 million. It is simple, memorable and widely accepted. It is also widely misunderstood. A rule of thumb is useful until we forget that it is only a rule of thumb. When the shortcut replaces the analysis, we can end up answering a question that was never asked.
What eventually became known as the 4% rule traces back to financial planner William Bengen's landmark 1994 research. Bengen examined historical market returns and asked how much a retiree could initially withdraw from a portfolio, increase that withdrawal for inflation each year, and still have the money to survive a 30-year retirement, including some extraordinarily difficult periods for investors. It was thoughtful work, and one of its important insights was that retirement income has to be considered in real, inflation-adjusted terms. The problem came later, as a sophisticated withdrawal methodology was simplified, repeated and eventually used to answer a somewhat different question.
The shorthand also obscures what Bengen was actually measuring. His finding was an initial withdrawal rate designed to survive difficult historical market conditions over a 30-year retirement. It was not simply 4% of the portfolio each year. The first year's withdrawal established a dollar amount, and subsequent withdrawals increased with inflation. So a retiree beginning with $2.5 million might withdraw about $100,000 in the first year, $103,000 the next year at 3% inflation, and roughly $236,000 by year 30. Bengen wasn't ignoring inflation, and he wasn't trying to calculate the minimum amount of capital needed to produce a particular income. He was testing how much a retiree could initially withdraw while surviving some very difficult historical markets.
Over time, however, we began asking the 4% rule to do something it wasn't designed to do: tell us how much we need to retire. Someone says, “I need $100,000 a year in retirement.” We divide $100,000 by 4% and conclude that the person needs $2.5 million. The calculation is so familiar that we rarely stop to ask whether we have answered the right question. And that is where I believe the overcapitalization of retirement begins.
The consequences aren't merely mathematical. Someone who needs $100,000 of retirement income may look at the familiar $2.5 million target, have $2 million accumulated and conclude that retirement has to wait. Someone who has accumulated the $2.5 million may retire but continue limiting spending because $100,000 has become the amount he or she believes is “safe.” In one case, a person may work longer than necessary. In the other, a retiree may spend less than the assets could reasonably support. Either way, a rule of thumb has begun making decisions that should have been made through planning.
We tend to treat overcapitalization as though there is no downside. After all, who ever complained about having too much money? But retirement capital has a purpose. Money unnecessarily preserved at 90 could represent experiences not enjoyed at 70, support not provided to children or grandchildren when it might have mattered most, or years spent working toward a number that was never actually required. Being prudent matters. So does understanding the cost of being too prudent.
This is where the real rate of return becomes important. For illustration, assume a retirement portfolio invested 50% in stocks and 50% in bonds, with long-term returns of 8% and 6%, respectively. That gives us a 7% nominal portfolio return. Now assume 3% inflation. Most people would simply subtract 3% from 7% and call the real return 4%. That's close, but the actual calculation is:
Real Rate of Return = [(1.07 ÷ 1.03) − 1] × 100 = 3.88%
I use 3.88% as a real discount rate in my retirement-income calculations. Retirees don't live on nominal returns; they live on purchasing power. A portfolio may earn 7%, but if the cost of living is rising 3%, purchasing power isn't increasing by 7%. Interestingly, my 3.88% real return is remarkably close to Bengen's 4%. What matters next is how we use it.
Now let's actually apply that real return. Suppose someone wants $100,000 a year, in today's purchasing power, for 30 years. I approach that differently. Using a financial calculator, I assume a 3.88% real return, 30 years and $100,000 of annual income beginning immediately. Then I make one assumption that changes the conversation: I assume the portfolio is fully consumed over the 30 years, leaving a balance of zero and no remaining legacy value. Under those assumptions, approximately $1.82 million is required today—not $2.5 million.
Why zero? Because I am giving that particular pool of money a job. Its job is to provide retirement income for 30 years. If I also want to provide a legacy, I treat that as a separate objective. This does not mean planning to die broke. It does not mean every asset should be exhausted. Other money can remain liquid, continue growing, provide a reserve or ultimately pass to the next generation. I am simply not requiring the dollars assigned to retirement income to provide 30 years of inflation-adjusted income and still be there afterward. Once we require the same portfolio to do both, we necessarily need more money. That is what I mean by overcapitalizing retirement.
There is an important consideration in my $1.82 million calculation, and it shouldn't be overlooked. Markets do not conveniently deliver a smooth 3.88% real return every year. A retiree could encounter a severe bear market during the first few years of retirement, and taking withdrawals while a portfolio is declining can permanently damage its ability to recover. The retiree could also live longer than 30 years. My calculation therefore leaves the retiree exposed to market risk, sequence-of-returns risk and longevity risk. Bengen's work was designed to address the uncertainty of actual historical investment returns, so simply declaring the roughly $680,000 difference between $1.82 million and $2.5 million unnecessary would be unfair. The better question is whether accumulating additional capital is the only way to address those risks.
Consider a sample income-annuity illustration. A 65-year-old man wants $100,000 of initial annual lifetime income, increasing 3% every year. He also wants a cash-refund provision so that, if he dies before receiving payments equal to the premium paid, the unrecovered premium is paid to his beneficiary. The illustrative premium is approximately $1.96 million. That is about $140,000 more than my 30-year calculation, but the two approaches are not providing the same thing. With the $1.82 million investment approach, the retiree retains market and sequence risk and the risk of living beyond the 30-year planning period. With the $1.96 million annuity, the market and longevity risks associated with that income stream are transferred to the insurer, subject to its claims-paying ability. The income continues if the retiree lives to 95, 100 or beyond, and market declines do not reduce the contractual payment.
Risk, of course, doesn't disappear. It changes hands and changes form. The annuity premium is no longer liquid capital available for other purposes. The guarantee depends upon the insurer's claims-paying ability. And the 3% annual increase protects against 3% inflation; not necessarily whatever inflation actually turns out to be. The retiree also gives up the upside that annuitized capital might have earned in stronger markets. Those are real tradeoffs. But now we are doing something more useful than applying a rule of thumb. We are identifying the risks, deciding which ones we are willing to retain and considering the cost of transferring others.
Now put the three numbers next to one another. Approximately $1.82 million funds our hypothetical 30-year income requirement under the real-return assumptions, with the portfolio fully consumed over that period and the retiree retaining the investment and longevity risks. Approximately $1.96 million, using the sample illustration, purchases $100,000 of initial lifetime income increasing 3% annually, transfers specified risks associated with that income to an insurer and includes cash-refund protection. Apply the familiar 4% shorthand in reverse and we arrive at $2.5 million. The difference between the sample annuity and $2.5 million is approximately $542,000. I am not suggesting that one of these approaches is universally better. I am suggesting that a difference of more than half a million dollars should cause us to do some analysis before automatically accepting $2.5 million as the amount “needed.”
Inflation cannot be a footnote in that analysis. A $100,000 lifetime income that never changes is not equivalent to $100,000 that increases every year. At 3% inflation, $100,000 received 30 years from now has purchasing power of only about $41,000 in today's dollars. Maintaining purchasing power has real economic value. Bengen's methodology recognized that. Our sample annuity recognizes it. Any fair comparison of retirement-income strategies should recognize it as well.
Then we encounter one of the strongest emotional objections to an income annuity: “I don't want to give up my money.” I understand it. Someone spends 30 or 40 years accumulating retirement assets and finally reaches a substantial balance. Converting a portion of that balance into an income stream can feel like watching the money disappear. But the money hasn't disappeared. It has been exchanged for something else. The retiree has used capital to purchase a contractual stream of lifetime income. What has been surrendered is liquidity and control over those particular dollars. That matters. What is received in exchange matters too: contractual income that isn't reduced by tomorrow's stock market decline and cannot be outlived, subject to the insurer's claims-paying ability.
There is an irony here that I find difficult to ignore. For years Americans have complained about the disappearance of traditional defined-benefit pensions. We remember pensions fondly because they provided a paycheck for life. Then employers moved toward 401(k)s and other defined-contribution plans, and employees began accumulating visible account balances instead. Once we could see the lump sum and call it “our money,” our attitude changed. Suggest using some of that money to create pension-like lifetime income and the response becomes, “I don't want to give up my money.” We complain that employers stopped providing pensions while resisting the idea of using some of our own retirement capital to recreate one. Perhaps seeing the account balance has caused us to confuse possessing retirement capital with what that capital was accumulated to accomplish.
For people fortunate enough to have accumulated substantially more than they will ever need, there is another question worth considering: What exactly are we trying so hard to preserve? Traditional IRA and 401(k) assets are generally tax-deferred, not tax-free, and may not always be the most tax-efficient assets to leave to the next generation. There is no universal rule about which assets should be spent first; taxes, Roth strategies, charitable intentions and estate objectives can change the answer. But if you have more than enough and intend to leave a legacy, it is worth asking whether your retirement account is really the asset you should be trying hardest to preserve.
Perhaps retirement planning should begin by giving every dollar a job. Some dollars need to provide dependable income. Some need to remain liquid. Some need to grow. Some may be intended for the next generation. Some simply provide the freedom to change our minds. Once we identify those jobs, we can determine how much capital each actually requires instead of automatically asking for every retirement dollar to accomplish everything.
The problem isn't the 4% rule.
It is what happens when a useful rule is misinterpreted, then misapplied, and finally repeated so often that the misapplication becomes conventional wisdom. A rule of thumb should be the beginning of the analysis, not a substitute for it. Before deciding that $100,000 of retirement income requires $2.5 million of retirement capital, perhaps we should ask a more basic question: How much capital does the income we actually need require? We may find that the answer is very different.
Retirement decisions deserve more than rules of thumb. They deserve someone willing to question the assumptions, do the math and look at the problem from more than one perspective. If you are approaching retirement and would value a thoughtful second look at how your assets can support the life you have worked to build, I would welcome the conversation.
The annuity figures used in this article are sample illustrations provided solely for educational purposes. They are not a recommendation, offer or solicitation to purchase any financial or insurance product. Actual benefits and premiums vary based on age, contract provisions, insurer, interest-rate environment and other factors. Investment-return and inflation assumptions are illustrative and are not guarantees of future results.
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