The planning horizon for the 4% rule is 30 years, but how long will your retirement really last?
One of the key difficulties of planning a retirement income strategy is that this question is difficult to answer. We may know our life expectancy, but that is just an average and there is a great deal of variability around that average. To be conservative, one must definitely plan to live longer than their life expectancy.
The idea behind planning for a specific retirement duration is to choose a sufficiently long time horizon that one is unlikely to outlive, and to then plan based on that. In 1994, Bill Bengen thought that 30 years was a reasonable planning horizon for 65 year olds. The planning age in this case is 95. Others use 100 or 105 as planning ages.
To repeat a fundamental point which is sometimes overlooked, the 4% rule applies specifically to a 30-year horizon. Those who are either younger or older than 65 may need to plan for more or less than 30 years. And even 65 year olds may wish to plan for different retirement durations depending on how conservative they wish to be with their choice. A 65 year old planning to live to 100 or 105 would need to plan for a 35 or 40 year horizon.
The retirement duration is important because longer time horizons will guide optimal retirement income solutions toward:
- Lower withdrawal rates
- Higher stock allocations
- Greater reliance on guaranteed income retirement products
- An implied end date for building a bond ladder (and perhaps forgetting about the possibility of living even longer)
The risk (and this risk varies from person to person depending on how much value they would get from additional spending) of planning for an overly long retirement is that you cut spending and miss out on enjoying your hard-earned wealth. It is conservative to plan for a longer horizon, because it means you will need to spend less and may end up leaving a larger than planned bequest. This risk is missing from traditional safe withdrawal rate studies which focus only on minimizing failure. On the other hand, the risk with planning for a shorter horizon is that you may overspend and end up outliving your wealth.
We can see further about the role of retirement duration on sustainable withdrawal rates in the following figure I've made. Using the historical data since 1926 and all of thebaseline assumptions, including a 50/50 allocation to large-capitalization stocks and intermediate-term government bonds, this figure shows William Bengen's SAFEMAX withdrawal rate for retirement horizons between five and 40 years. To be clear, the SAFEMAX withdrawal rate is the highest sustainable withdrawal rate in the worst-case historical scenario.
William Bengen gave us the 4% rule using this methodology, and we can see here in this figure that the SAFEMAX for a 30-year retirement is 4.04%. This figure illustrates a curve in which the SAFEMAX declines, but at a decreasing rate, as the retirement duration increases.
Related to this, let's also consider the Required Minimum Distribution rates set by the IRS for tax-deferred retirement accounts. Those requirements apply after age 70.5, but those with inherited IRAs may have to withdraw at earlier ages as well using these rules. For this reason, the IRS provides these RMD rates for ages less than 70 as well.
The next figure compares the RMD withdrawal rates to the historical SAFEMAXs assuming a planning age of 100. These curves are relatively close together, though do notice that the RMDs become more conservative as one approaches age 100. This makes sense, since as one approaches their planning age, it becomes increasingly likely that one will live beyond the age. The IRS RMD rules are also conservative relative to the SAFEMAX for ages under 75, though do understand that these SAFEMAXs are for a 50/50 portfolio and will be lower for someone with a lower stock allocation.
I also worry that with current interest rates so low, the historical SAFEMAX numbers do not tell the whole story about how low withdrawal rates can fall, as sequence of returns risk matters.
Though the spending rate will be more volatile, using the RMD rules to set withdrawal rates for each year of retirement does present a viable alternative to using constant inflation-adjusted withdrawal amounts.
It is worth thinking about more as a way to understand the key lesson here: the 4% rule applies only to a 30-year retirement period, not more and not less.