The widespread acceptance of the 4% rule within the investment management industry is only overshadowed by the sheer number of its shortcomings.

The 4% rule was introduced by Larry Bierwirth in 1994 (Investing for Retirement: Using the Past to Model the Future) and expanded on by William Bengen in the same year (Determining Withdrawal Rates Using Historical Data). In the conclusion of his paper, Bengen states that a client age 60-65 planning for a 30-year retirement should withdraw 4% of the initial portfolio value, adjusted for inflation, each year. While many variations of the rule exist, the basic idea remains the same:

1) Make assumptions for securities return distributions, inflation, life expectancy, risk tolerance, taxes, transaction costs, etc. 2) Determine the fixed withdrawal percentage that minimizes the probability that the portfolio will fail to fully fund spending over the retirement horizon.

Most criticisms of the 4% rule focus on the impact that assumption changes have on the optimal withdrawal percentage (i.e., a 15-year versus a 30-year retirement horizon, a conservative versus an aggressive asset allocation, etc.). It is not surprising that if we change basic assumptions about the investor or test the withdrawal strategy over a different time horizon, the optimal withdrawal rates (with the benefit of hindsight) will differ. In fact, Bengen acknowledges in his original paper that 4% is specific to a 30-year retirement horizon and a 50/50 stock/bond allocation. 

The problem with the 4% rule lies not in the specific assumptions used for a given investor or in its specific implementation, but in its underlying theory. Most important, the 4% rule fails because it attempts to fund a static spending rule (fixed withdrawals adjusted for inflation) with a dynamic funding source (financial returns). 

In most aspects of our lives, we try to match static (or dynamic) spending rules with static (or dynamic) funding sources. If my house burns down, I will need to pay to have it rebuilt. This is an example of a dynamic spending rule since I cannot predict if or when my house will burn down. To deal with this risk, most people buy a home insurance policy. The policy is also a dynamic funding source since it pays off only if my house burns down. By matching the correct dynamic funding source to the dynamic spending need, I have largely mitigated my risk.

Nobel laureate William Sharpe discusses this problem in a critique of the 4% rule (The 4% Rule—At What Price?) Specifically, Sharpe argues that the 4% rule was developed with the objective of minimizing the probability of failing to fully fund retirement withdrawals and ignored other important metrics that should be used to evaluate a withdrawal strategy. 

The most important of these metrics is the cost of surplus—the value of funds left unused when the investor dies (after money left for others is accounted for). The remaining portfolio balance is considered a cost because the excess funds could have been used to increase withdrawals during retirement. Investors can on average spend more during retirement with a lower probability of prematurely exhausting retirement savings by eschewing the 4% rule (or a similar static variant) for a dynamic withdrawal policy that depends on the realized market path. 

A simple example can illustrate both the importance of considering multiple metrics and the valued added by employing simple dynamic withdrawal policies. Consider a 65-year-old retiree with $1 million in the bank to fund retirement. The retiree would like to plan for a 30-year retirement and figures that he needs $40,000 for living expenses per year. The real interest rate is assumed to be 2% and the retiree’s financial advisor has invested in a portfolio with an expected return of 6% and volatility of 13%. 

We used Monte Carlo methods to simulate 100,000 potential market paths. Although we make some simplifying assumptions in the simulations (normally distributed returns, constant correlations between assets, etc.), the results are still useful in comparing various withdrawal strategies. Using these paths, we can compute the failure probability, the cost of surplus and the total risk-adjusted present value of withdrawals. 

• Probability of Failure: 5%. There is a 95% chance that the retiree will be able to withdraw an inflation-adjusted $40,000 for all 30 years of retirement. 

• Cost of Surplus: 20.8%. On average, 20.8% of the initial portfolio value ($208,000) ends up as excess funds that were not used during retirement. Looked at another way, the retiree could have spent $208,000 more in today’s dollars over the course of retirement if he had used an optimal withdrawal strategy.

• Risk-Adjusted Present Value of Withdrawals: $795,000. The value of all withdrawals adjusted for the time value of money and the higher relative value of cash in future states of the world where security returns are lower.

We applied a number of simple dynamic spending rules and then recomputed the three statistics to show the improvement relative to the 4% rule. One potential rule is to withdraw 4% of the current, instead of original, portfolio balance, subject to a floor. For more conservative retirees willing to live on $30,000 in down markets, we can set the floor at $30,000. This reduces the probability of failure from 5% to 1.1% while maintaining a similar cost of surplus (21.1%) and risk-adjusted present value of withdrawals ($790,000).
For investors who are willing to take more risk in return for higher potential withdrawals, we can set the floor at $40,000. This reduces the cost of surplus from 20.8% to 14.6% and raises the risk-adjusted present value of withdrawals from $795,000 to $856,000, while leaving the probability of failure nearly unchanged at 5.3%. 

We can get even better results by making our rule more dynamic. One way of achieving this is to choose the percentage of the current portfolio value withdrawn based on the ratio of the current portfolio balance to the years of retirement remaining. For example, if we have less than $30,000 per year of retirement in the portfolio, we will withdraw 4%; if we have $30,000-$40,000 per year of retirement, we will withdraw 5%. And so on. With this strategy we improve on all three metrics: The probability of failure is 1.8%, the cost of surplus is 6.1%, and the risk-adjusted present value of withdrawals is $940,000. 

These dynamic withdrawal rules improve on the 4% rule because they react to the realized market path. They do not make predictions. Predictive models are most effective when current market conditions mirror history. The traditional 4% rule depends strongly on the assumption that future markets will look like past markets.
Despite all this talk of dynamic withdrawals, some stability is necessary for budgeting purposes. It seems best for withdrawals to be dynamic, yet they shouldn’t change daily like the financial markets. 

If we talk about matching the nature of the spending with that of the funding source, that means the portfolio behavior itself should be more stable. But most individuals and firms have little or no ability to control the financial markets, so how can they possibly make portfolio returns more stable?

Such stability can be achieved with quantitatively enabled tactical strategies to protect against drawdowns. By effectively safeguarding capital in turbulent market regimes, investors with specific withdrawal needs can increase spending without an increased probability of prematurely exhausting their asset pool. 

We illustrate the value of combining dynamic withdrawals and drawdown management with an example. Assume that the retiree uses the withdrawal strategy whereby the percentage withdrawn varies along with the ratio of portfolio value to retirement years remaining. In addition, assume that portfolio drawdowns are limited to 10%. With these assumptions, the probability of failure is reduced to zero, the cost of surplus falls to 1.8% and the risk-adjusted present value of withdrawals increases to $1,013,000. Combining dynamic withdrawal management with downside portfolio protection allows retirees to spend more in retirement while also having more peace of mind that their nest egg will last.
However, for drawdown protection to be truly successful during a person’s retirement, he must not only avoid large losses but also do so without sacrificing too much upside. This requirement, along with the continued elevated correlation levels among asset classes, eliminates most traditional portfolio risk management techniques, including options and diversification, from consideration. In today’s market environment, tactical portfolio management provides the best avenue to achieve the necessary asymmetric return profile in a cost-effective manner.

In summary, retirees and their financial advisors can greatly improve on the results delivered by the 4% rule through the following three-step process:

1) They must determine a retiree’s characteristics and objectives.

2) They must enhance portfolio behavior through rules-based, quantitatively enabled tactical strategies that focus on downside capital protection.

3) They must dynamically adjust withdrawals to coincide with the realized market path to both increase spending and peace of mind throughout retirement.

Corey Hoffstein is co-founder, chief investment officer and chief technology officer of Newfound Research, a financial technology and product innovation firm that works with clients to develop behavior-driven investment strategies.