Why You Shouldn’t Use the 4% Rule In Retirement (And a Better Strategy)

Subscribe where ever you listen to Podcasts:

Spotify Podcasts
Apple Podcasts
Google Podcasts

Resources:

"A different strategy is going to be one that can be flexible and solve these issues better than the 4% rule.”

Can you really rely on the 4% rule for a comfortable retirement? In this episode, our host Danny Gudorf tackles this controversial topic head-on, revealing why this popular rule might lead you astray. Danny dissects the four major pitfalls of the 4% rule while offering a superior strategy to help you retire sooner and generate more income.

By examining hypothetical portfolios and different investment return scenarios, you'll gain a clear understanding of how to create a more stable and sustainable income stream for retirement.

Key Topics:

  • What is the 4% Rule? (00:36)
  • Portfolio Withdrawals and Inconsistency with Inflation (02:25)
  • A Retirement Income Example (03:21)
  • The 1 Million Dollar Portfolio Example (05:54)
  • The Better Solution: Dynamic Income Solution (09:55)
  • Wrap-Up (13:59)

Rethinking Retirement: Why the 4% Rule May Be Holding You Back

Key Takeaways:

  • The 4% rule, while popular, has significant limitations for modern retirees
  • Four major issues with the 4% rule: inflexible withdrawals, sequence of returns risk, over-conservatism, and fixed retirement length assumptions
  • A dynamic income strategy with retirement income guardrails offers a more flexible and potentially rewarding approach
  • Customizing your retirement strategy based on your unique circumstances can lead to a more fulfilling retirement experience

As you approach retirement, you've likely encountered the famous "4% rule" - a guideline that's been a cornerstone of retirement planning for decades. But what if I told you that relying on this rule could be a big mistake? In this post, we'll explore why the 4% rule might be holding you back from achieving your ideal retirement and introduce a more flexible, dynamic approach that could help you retire sooner and create more income during your golden years.

Understanding the 4% Rule: A Quick Refresher

Before we dive into the limitations of the 4% rule, let's quickly review what it entails. The 4% rule suggests that retirees can safely withdraw 4% of their total portfolio balance in the first year of retirement and then adjust that amount annually for inflation. The idea is that this withdrawal rate should sustain a 30-year retirement without depleting your savings.

For example, if you have a $1 million retirement portfolio, the 4% rule would allow you to withdraw $40,000 in your first year of retirement. If inflation were 3% the following year, you'd increase your withdrawal to $41,200.

At first glance, this seems like a straightforward and reliable approach. However, as we'll explore, the 4% rule has several significant flaws that could impact your retirement plans.

The Four Major Flaws of the 4% Rule

1. Inflexible Withdrawals: Life Doesn't Follow a Straight Line

The first major issue with the 4% rule is its assumption that your portfolio withdrawals will remain constant (adjusted only for inflation) throughout your retirement. This rigid approach fails to account for the dynamic nature of retirement income and expenses.

Changing Income Sources

Many retirees have additional income sources that kick in at different times during retirement. For instance, you might delay taking Social Security benefits to maximize your payout, or you could have a pension that starts at a specific age. The 4% rule doesn't factor in these changing income streams.

Fluctuating Expenses

Your expenses in retirement are likely to change over time. Many retirees find that they spend more in the early years of retirement when they're more active and able to travel. As they enter their late 70s and beyond, spending often decreases. The 4% rule's fixed withdrawal approach doesn't align with this reality.

Real-Life Example: Michael and Jan

Let's consider a hypothetical couple, Michael and Jan, who are retiring at age 62 with a $1 million portfolio. Following the 4% rule, they would withdraw $40,000 annually, adjusted for inflation. However, their actual income needs might look quite different:

  • Ages 62-70: They need more income as they're more active and haven't yet claimed all their Social Security benefits.
  • Age 70 and beyond: Their income needs may decrease as they become less active, but they'll receive higher Social Security payments.

The 4% rule doesn't allow for this kind of flexibility, potentially leaving Michael and Jan with too little income in the early years and excess income later on.

2. Sequence of Returns Risk: Timing is Everything

The second significant issue with the 4% rule is that it doesn't account for sequence of returns risk. This concept refers to the order in which you experience investment returns, which can have a dramatic impact on your portfolio's longevity.

The Impact of Early Negative Returns

If you experience poor market performance in the early years of your retirement, it can deplete your portfolio quickly. This is because you're not only losing value on your investments but also withdrawing money to fund your retirement. This double whammy can be challenging to recover from, even if markets improve later on.

The Benefit of Early Positive Returns

Conversely, if you experience strong returns in the early years of retirement, your portfolio can build a cushion that helps absorb future market downturns. This can significantly enhance your financial security and potentially allow for higher withdrawals later in retirement.

Historical Example: The Unlucky 1966 Retiree

Consider a retiree who began their retirement in 1966 with a $1 million portfolio invested 40% in stocks and 60% in bonds. Despite an impressive average annual return of 9.5% from 1966 to 2000, this retiree would have run out of money before age 90 if they followed the 4% rule. Why? Because the poor market performance and high inflation in the early years of their retirement significantly depleted their portfolio, and even the strong returns of the 1980s and 1990s couldn't make up for it.

This example illustrates how the 4% rule fails to address the very real risk posed by the sequence of returns in your portfolio.

3. Over-Conservatism: Leaving Money on the Table

The third problem with the 4% rule is that it's based on worst-case scenarios. While this might seem prudent, it can lead to unnecessarily conservative withdrawals for many retirees.

The Risk of Under-Spending

Most retirees won't face the worst-case scenario that the 4% rule is designed to protect against. As a result, many people following this rule end up dying with more money than they started retirement with. While this might seem like a good problem to have, it means that these retirees could have enjoyed a higher standard of living during their retirement years.

Missed Opportunities

By being overly conservative, retirees might miss out on:

  • Traveling more while they're younger and healthier
  • Helping their children or grandchildren financially
  • Supporting causes they care about through charitable giving
  • Pursuing hobbies or interests that require additional funds

The Balance Between Caution and Enjoyment

While it's crucial to ensure you don't run out of money in retirement, it's equally important to make the most of your retirement years. The 4% rule often tips the scales too far towards caution, potentially at the cost of your quality of life.

4. Fixed Retirement Length: One Size Doesn't Fit All

The final major flaw of the 4% rule is its assumption of a 30-year retirement period. This one-size-fits-all approach fails to account for the diverse retirement timelines that individuals may face.

Early Retirees

If you're planning to retire in your 50s, you might need your portfolio to last 40 years or more. In this case, the 4% rule might be too aggressive, potentially leading to running out of money in later years.

Later Retirees

On the other hand, if you're retiring in your 70s, you might be able to safely withdraw more than 4% annually, as your retirement horizon is shorter.

Health and Longevity Considerations

Your personal health and family history of longevity should also play a role in determining your withdrawal strategy. The 4% rule doesn't take these individual factors into account.

A Better Solution: Dynamic Income Strategy with Retirement Income Guardrails

Given the limitations of the 4% rule, what's a better approach for modern retirees? Enter the dynamic income strategy with retirement income guardrails. This flexible approach addresses the shortcomings of the 4% rule and can lead to a more fulfilling retirement experience.

How It Works

  1. Assess Your Retirement Horizon: Consider your expected retirement length based on your retirement age and life expectancy.

  2. Analyze Changing Income Needs: Map out how your income needs might change throughout retirement, factoring in things like travel plans, healthcare costs, and potential legacy goals.

  3. Determine Initial Income Level: Based on your portfolio and retirement timeline, establish an initial withdrawal rate that your portfolio can support.

  4. Set Up Guardrails: Create upper and lower limits around your portfolio balance. These guardrails dictate when you can increase your spending and when you need to cut back.

  5. Adjust As You Go: Regularly review and adjust your strategy based on portfolio performance and changing needs.

Benefits of the Guardrails Approach

  • Flexibility: Adapts to changing market conditions and personal circumstances.
  • Protection Against Sequence Risk: Allows for spending cuts in down markets to preserve portfolio longevity.
  • Upside Potential: Permits increased spending when markets perform well, enhancing quality of life.
  • Customization: Can be tailored to individual risk tolerance and spending flexibility.

Real-Life Example: Michael and Jan Revisited

Let's return to our hypothetical couple, Michael and Jan, and see how the guardrails approach might work for them:

  • Initial Portfolio: $1 million
  • 4% Rule Approach: $4,833 per month for the first 8 years, then a jump to $7,833 per month at age 70.
  • Guardrails Approach:
    • Initial spending: $6,000 per month
    • Upper guardrail (portfolio reaches $1.25 million): Increase spending to $6,500 per month
    • Lower guardrail (portfolio drops to $840,000): Reduce spending to $5,600 per month

This approach provides Michael and Jan with a more consistent income stream throughout retirement while still offering protection against market downturns and the potential for increased spending in good years.

Implementing Your Own Dynamic Retirement Strategy

While the guardrails approach offers significant advantages over the 4% rule, it's important to remember that every retiree's situation is unique. Here are some steps to help you develop a personalized retirement income strategy:

  1. Assess Your Risk Tolerance: Understand how comfortable you are with market fluctuations and spending adjustments.

  2. Evaluate Your Expense Flexibility: Determine which expenses are essential and which are discretionary. This will help you understand how much you can cut back if needed.

  3. Map Out Your Income Sources: Include Social Security, pensions, rental income, and any other sources of retirement income.

  4. Consider Your Legacy Goals: Decide how much, if any, you want to leave to heirs or charities.

  5. Factor in Health Considerations: Your health status and family history can impact your retirement timeline and expenses.

  6. Seek Professional Guidance: A financial advisor experienced in retirement planning can help you create a customized strategy that aligns with your goals and circumstances.

Conclusion: Embracing Flexibility for a Better Retirement

The 4% rule, while simple and well-known, has significant limitations in today's complex retirement landscape. By understanding these limitations and embracing a more dynamic approach like the guardrails strategy, you can create a retirement plan that's better suited to your unique needs and goals.

Remember, retirement planning isn't a one-time event but an ongoing process. Regularly reviewing and adjusting your strategy can help ensure that you're making the most of your retirement years while maintaining financial security.

Whether you're just starting to plan for retirement or you're already enjoying your golden years, consider moving beyond the 4% rule. Embrace a more flexible, personalized approach that can help you achieve the retirement you've always dreamed of.

*This blog post is based on the insights shared by Danny Gudorf of Gudorf Financial Group in an episode of the Limitless Retirement Podcast. For personalized advice tailored to your unique circumstances, always consult a financial, legal, or tax professional.*

Transcript: Prefer to Read — Click to Open

Danny (00:05.454)

Welcome to the Limitless Retirement Podcast. My name is Danny Goodorf, the owner of Goodorf Financial Group. Whether retirement is on your horizon or you’ve already made the leap, this podcast tackles your most important questions in retirement. Every episode, I’m here to share valuable tips and strategies to help you succeed in retirement. So let’s go ahead and get started with today’s show.

Relying on the 4 % rule to determine when you can retire could be a big mistake. In this video, I’m going to tell you four issues with this common retirement rule of thumb and a better strategy that could be used to help you retire sooner and create more income for yourself in retirement. To illustrate this, we’re going to look at an example of a couple, Michael and Jan, who are about to retire.

at age 62. But before we get into that, what is the 4 % rule? Well, it’s by far the most popular retirement rule of thumb, but I think it’s often misunderstood. What the 4 % rule says is that when you retire, you can withdraw 4 % of your total portfolio balance in the first year of retirement and increase that number annually

by inflation. And you can do that for any 30 year retirement timeframe and feel confident that you will never run out of money. So in our example, Michael and Jan, they have a $1 million retirement portfolio. The 4 % rule says that they could withdraw $40 ,000 from their investments in the first year retirement and increase that $40 ,000 number each

by inflation. So if inflation in the first year was 3%, then their portfolio withdrawals in year two would increase from $40 ,000 to $41 ,200. And it would keep on increasing every year in retirement by the inflation number. Now, the first major flaw with the 4 % rule is the assumption that portfolio withdrawals remain constant

Danny (02:34.474)

adjusted for inflation throughout your retirement. This doesn’t take into account other income sources that may show up later in retirement like Social Security or a pension. It also doesn’t account for changing expenses. Most retirees spend more in the early years of retirement while they’re physically able to, but less as they get into their late 70s and

This can mean that you need to withdraw more from your portfolio early on, especially if you don’t start Social Security benefits till later. So a fixed dollar amount doesn’t really make sense in these examples. In Michael and Jan’s case, they decide they’re going to take Jan’s Social Security at 62 when she retires and her benefit is going to be $1 per

Michael is going to wait to claim his benefit till age 70 when it will be worth $3 ,300 per month. If we look at their retirement income picture, they’re going to have the $40 ,000 from their portfolio withdrawals, which comes out to about $3 ,333 per month. Plus they’ll have the $1 per month from Jan’s Social Security.

Their total income of $4 ,833 per month is going to be their starting retirement income. And that’s going to be their standard of living for the first eight years of retirement. Then they’ll get a big pay bump from Michael’s Social Security at age 70 when their total monthly income would be $7 ,833 per month. Looking at this,

we can already see that it makes no sense. It would be much better if their retirement income was smoothed out over time. Another significant issue with the 4 % rule is what’s known as sequence of returns risk. The idea here is that in order in which you receive your returns on your investments can drastically

Danny (05:02.316)

the sustainability of your retirement income. Negative portfolio returns early in retirement can deplete your portfolio really quickly because not only are you losing value on your retirement investments, but you’re also taking money from the portfolio to provide that retirement income. If instead you had good or even average returns early

then your portfolio would build a cushion beyond what you need to withdraw in retirement in order to absorb those future negative returns. So strong early returns can enhance your financial security and stability. Let’s take a look at an example. In this example, it’s showing us $1 million portfolio.

If this portfolio was invested in 40 % stocks, 60 % bonds, and I’m not recommending this, this is just an example. Foreign investor retiring at age 65 in 1966. And the reason that we’re using 1966 is because over the last 100 years, that was the worst time you could have retired. If they were following the 4 % rule, we would assume

they would be fine. And with the benefit of hindsight, we know that a 40 % stock, 60 % bond portfolio had an annual return of 9 .5 % from 1966 to 2000. So you would think they definitely would be fine with that great average rate of return. But what happened in reality? They ran out of money before age 90. How did this happen? This happened.

because the returns in the first several years after retiring were not good. And inflation in the seventies was extremely high. There were some great years in the eighties and nineties, but by the time their portfolio got there, it was so depleted that those good returns couldn’t make up for the withdrawals and the poor market performance. The 4 % rule doesn’t leave room to adjust

Danny (07:29.038)

this risk. But at the end of this video, I’ll go over a better strategy that will give you more protection against sequence of return risk. The third problem with the 4 % rule is that it’s based upon worst case scenarios. We just looked at one. So basing withdrawals on a worst case scenario may not sound like a bad idea. However, most of the time,

you’re not going to be retiring into a worst case scenario. So most of the time, the 4 % rule is going to be too conservative and cause many retirees to die with more money than they started with in retirement. And I know most of my clients, this is not something they are looking to achieve. This may sound like a good problem to have, and it’s definitely better than the opposite end of the spectrum.

like running out of money, but it means that many retirees could have used more of their money while they were still young and still able to travel and do things. They could have helped out their kids more or maybe even been more generous to charities while they were alive during their lifetime. This potential could increase their quality of life during their

So we should strive to incorporate a strategy that allows us to make the most of our money while we’re still living. The final issue with the 4 % rule is it’s based upon a specific retirement length, which may not be your retirement length. The original studies assume a 30 year retirement, but not everybody is going to fit into that box. Somebody

Retiring in their 50s should plan on a much longer retirement. So the 4 % rule may not work. On the other hand, somebody who’s retiring in their 70s may be able to safely spend way more than 4%. Differing life expectancies and retirement ages require adaptive strategies, not a one size fits all approach.

Danny (09:53.452)

This leads me into the better solution. In light of all of these issues we discussed, changing income needs from the portfolio, sequence of returns risk, not leaving too much money on the table unspent, and differing retirement time horizons, a different strategy is going to be one that can be flexible and solve these issues better than the

The strategy that we use with our clients that fits this bill is a dynamic income strategy with retirement income guardrails. Let’s dig into exactly how this works. A retirement guardrail strategy is going to look at your likely retirement time horizon and changing income needs in your retirement years. Then we’re going to determine an initial income level

that the portfolio can support. Next, we place guardrails around the portfolio balance, which tell you when you can increase your spending and when you need to cut back on some of your spending. If portfolio returns are good, then you get a bump in your spending and lessen the chance that you leave too much money on the table. But if returns in those early years are bad,

and we experience that sequence of return risk, then we can cut back on spending to let the portfolio be able to recover before eventually increasing spending again. To illustrate this, let’s go through another example back to Michael and Jan. We already showed how the 4 % rule would create a non -sensible retirement income. Well,

If Michael and Jan were to instead use a dynamic income strategy with guardrails, what would that look like? Instead of retirement income in those first eight years of $4 ,833 per month, when we smooth out their income using their retirement income guardrails, then they could spend roughly $6 ,000 per month starting at age 62.

Danny (12:13.678)

That’s a significant increase in their standard of living. Then what we need to do is we put guardrails around their portfolio balance. And we say, if your portfolio increases to 1 .25 million, then you can increase your spending to $6 ,500 per month. But if your portfolio decreases to 840 ,000, then we would need to cut back on your monthly spending.

to around $5 ,600 per month. So that kind of shows us an example of what the retirement income guardrails would look like. Now, the way we determine what the initial retirement withdrawal rate would be and where those guardrails are will depend upon a lot of factors, like Michael and Jan’s risk tolerance, how flexible their expenses are in retirement.

If they’re very flexible and don’t mind adjusting their spending with market returns, then maybe we increase that initial spending level a little bit and make the guardrails a little bit tighter. But if instead they want a more predictable income, then we could set that initial income lower and make the guardrails a little wider. The point

using a dynamic income strategy with guardrails in retirement addresses all of those limitations that the 4 % rule provides and can lead to a better overall retirement experience. So that is all we have for today about the 4 % rule and our retirement income guardrails. So I appreciate you watching today. And if you’re still in the saving years for retirement,

and you’re trying to hit that magic number that says you can retire, then check out my video right here or in the show notes about how much do I need to retire? Five numbers to help you decide. At Gouda Financial Group, we create custom retirement plans for our clients. We optimize their investments. We look at their retirement income, taxes, insurance, and everything else. So this sounds like something

Danny (14:37.57)

that could be helpful, then let’s have a conversation. Go to gudorfinancial .com forward slash get started to learn more about our free retirement assessment process. Have a great day and happy retirement. Thank you for listening to another episode of the Limitless Retirement Podcast. If you want to see how Goudor Financial Group can help you get the most out of your money, go to

goudorffinancial .com forward slash get started. This is where you can schedule a 20 minute call to see how our firm can help prepare a free retirement assessment. Please remember, nothing we discuss on this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional that is familiar

with your unique circumstances before making any financial decisions.

Back to All Episodes