What Else Is Wrong with 4%?

In yesterday’s post I opined as to what I fundamentally disliked about the 4% Plan for determining your retirement allowance. Now here’s another thing. Four percent may well be the wrong number.

First, a recap. The 4% Plan is a spending plan you might adopt as you embark on your retirement. You spend 4% of your retirement assets, and then increase that annually with cost of living adjustments. The fundamental flaw in this plan is that for many people it gives up too much of an affordable lifestyle in exchange for more certainty as to your allowance from year to year.

But there’s another problem. It appears that 4% is too small a percentage! In a lapidary article appearing in the Journal of Financial Planning, David Blanchett and Brian Blanchett point out a flaw in the literature that has been hiding in plain sight. Perhaps your initial spending percentage should be 5%. It very much depends on your age and your tolerance for uncertainty.

Their argument goes something like this. The financial planners who zeroed in on 4% basically did two separate analyses to get there. First, they analyzed how long a retirement fund ought to last. To be conservative, they chose a long period, e.g., one that no more than 15% of 65 year old couples would survive (30 years). Then they analyzed, for a given investment strategy (60% equities, 40% bonds), what withdrawal rate (4%) would result in a high probability (95%-96%) of lasting the entire period. But the flaw in that reasoning, as pointed out by the authors, is that for the 4% withdrawal rate to fail during the couple’s lifetimes, two unlikely events would have to occur simultaneously: a really long life and a really bad investment period.

So the authors refigured the probability of both events occurring, and concluded that a 4% withdrawal rate does not carry a 4%-5% risk of failure, but rather a 0.7% risk of failure, i.e., running out of money before running out of heartbeat. To ratchet up to a 4%-5% risk of failure, the initial withdrawal rate should be 5%, a 25% increase in spending from your retirement assets. That’s a pretty substantial leap in lifestyle: Outback Steaks instead of McDonalds; the Caribbean instead of Rockaway Beach; whatever.

Of course 99% confidence is better than 95% confidence. But at what price? Is the incremental certainty worth the cost? Only you can make that judgment. But the important thing is that the underlying trade-offs not be hidden from you.

So maybe the 4% Plan should be the 5% Plan. As I said in yesterday’s post, I don’t care for the 4% Plan. And for the same reasons I don’t care for the 5% Plan. I think many people are better off giving up the quasi-certainty of either approach and getting a (likely, but variable) higher standard of living in exchange.

What do you think? If you had $1 million, would you rather have a mostly unvarying $50,000 standard of living, or a varying $60,000 standard of living?