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The 4% Rule Is A Terrible Retirement Income Strategy (Here's Why) · Retirement Answers

0:00
Jacob Duke: Hey friends, and welcome back to another episode of Retirement Answers. My name is Jacob Duke. I'm your host as always. Today on the show, I wanna talk about a common misconception or a lie that many retirees are believing that is otherwise gonna create many issues for them down the road, and they might not figure it out until too late. So I wanna talk about that in just a moment.
0:20
But first, if you're new here, welcome again, my name is Jacob Duke. I'm a certified financial planner and the owner of River Tree Wealth, a retirement planning firm that helps people just like you plan smarter and retire better. So, what is this thing? What is this lie or misconception that many retirees are basing their retirement on that will otherwise be a mistake? It's the 4% rule.
0:42
It's this set amount of money as a percentage that they can or cannot take from their savings and not run out of money. Right? So there's this mathematical equation that states if you take 4% out of your portfolio over the next thirty years and adjust that 4% upwards for inflation each year over that amount of time, and you allocate your dollars in a sixtyforty or something of the like mix from a stock to bond to cash ratio, you will get to the end of that thirty year period and still not have run out of money. Now, that's based on historical data. And today I don't wanna argue with you about the percentage, okay?
1:19
I wanna argue with the framework and the idea of having a set percentage as a whole. The idea itself in my opinion is flawed because as someone who actually does retirement planning with many people, hundreds of people and has done this over the last seven plus years, I've seen that nothing happens in a linear fashion. Nothing when it comes to retirement happens the way you often expect it to, or at the times you expect them to happen. So here's the main problem with the 4% rule. It's not that it's mathematically incorrect, I'm not gonna argue with that.
1:49
What I am gonna argue with though, is that it doesn't really work well in real life. What it really leads people to is this strict formulaic way of how much they can or cannot spend out of their portfolio over time. Now here's the main problem. I just have seen anecdotally that this year spending doesn't happen in a linear fashion. Some years it's higher, some years it's lower.
2:10
Some people have more spending on the front end of retirement. In fact, we'll talk about that more in just a moment. Some people have less spending on the back end of retirement, right? So nothing happens in a linear fashion. And that's the main problem I have with the 4% rule or any percentage distribution rule, is that it doesn't work in real life.
2:27
And the biggest risk that I've seen with this is that you end up underspending in the years of your retirement that you should be spending the most and enjoying the most and living the most. You're not because you're trying to hold tightly to this 4% rule. But if you would spend five or 6% of your portfolio, you can go on the extra trip or go visit the kids more or do the thing that you've always wanted to do, the home remodel, the car purchase, whatever it is, right? You're holding out because you have to hit this 4% rule. If you go over, you're gonna run out of money.
3:00
Okay? That's the main issue that I see with following this rule so closely. You end up underspending early in retirement. Now stick around because I wanna share how this is not the most realistic thing here in just a moment. But what you end up doing is you end up missing out on the experiences.
3:17
You end up missing out on the life that you otherwise have worked hard for to earn and have the opportunity to go live. And maybe the biggest problem is that you end up with way too much money later on. There's many studies out there that indicate that retirees end up with more money than they started retirement with because they didn't spend enough, mostly because of fear, right? And so I think the four percent rule actually adds to this fear component and uses data, yes, but it doesn't integrate the nuance or the human side of retirement at all. So now one of the things that I've commonly seen is whenever someone says, hey Jacob, I need a $100,000 a year to live in retirement, right?
3:53
The problem there is if you do the 4% rule a $100, that would indicate that you need upwards of a $2,500,000 portfolio to support that using that 4% rule metric. Now, the hard part here is that many people are just thinking, hey, a $100,000 a year, that's what I need, right? That's what I wanna spend without factoring in any other forms of income such as social security or, a pension or rental income or disability or anything else that you might have. You're not factoring that into the equation. So really it's a 100,000 minus however much that would be.
4:25
That is how much you truly need from the portfolio. Therefore, the portfolio doesn't have to be as big. So I would say that many people are basing the decision and how much money they need based on this 4% rule on the wrong amount of money anyway. They're not factoring in the other sorts of fixed income they might have, whether it be presently or in the future. Now the question is, well Jacob, hey, what happens if I retire at 60 and then I don't take my social security at 67, that's my only other form of fixed income that I'll ever have.
4:55
How much can I take for my portfolio between 60 and 67, right? And what does that mean whenever I do get to 67 and I need $100,000 a year? And how much is my distribution rate at that point? And so there's a little bit of nuance that has to happen here. And this is why I don't like a set rule of thumb because yes, it could be a good thing to check your math with and see, hey, can I make this happen using that as a good kind of baseline?
5:18
But I would say that you could spend more and you will spend more as a percentage between 60 and 67 before you get to social security age ultimately to have that distribution rate from your portfolio drop off a cliff at that point, right? So that's coming, hey, I'm spending five, six or 7% of my portfolio year after year in those first five years or so. And then once I get my social security income for my spouse and I, or if you're single, just your social security income, that could be upwards of 50 or more percent of your spending need every single month. Therefore, your distribution rate out of your portfolio drops off a cliff. So you don't need as much money from the portfolio.
5:55
So that would mean that you have this higher distribution rate on the front end of retirement from the portfolio because you're gonna have this fixed income that's gonna reduce that distribution rate down once you do turn social security on at 67. So there's a lot of variability and nuance to consider here whenever you're thinking about how much you can or cannot take from your portfolio. Now, what I want to present to you is a different idea or a different way of thinking about how much you can or should take from your portfolio. I always think of this as how much can I spend in the front end of retirement, the first five, ten, fifteen years, depending on your age at which you do stop working? How much can I spend during these years?
6:35
These are my go go years. These are my prime health years, right? This is my chance to go travel the world if that's what I wanna do. This is my chance to rebuild the car if that's what I want to do. This is my chance to pay for the vacation for the family every single year to wherever your favorite spot to go is.
6:49
These are the years that you should do the things you've longed to do. Don't hold out any longer like this is the opportunity. So what I would say, the framework and the mindset I operate with is, hey, why don't we focus on spending as much as we possibly can in these early stages of retirement, but also without jeopardizing any sort of longevity risk on the back end, should we live to 90, 95, 100 years old. So there's this balancing act that has to take place. I'm gonna come back to that here in just a second, but there's a different and more realistic way of thinking about spending in retirement that I've come across and truly love, and it's called the retirement spending smile.
7:25
It's this idea that your spending increase or the rate in which you're spending is going up over time, it's higher on the front end of retirement because you are going, you're active, you're able to travel, you're able to spend more money on different things. And then it slowly decreases over time throughout retirement as you age, and then it might spike on the back end in the later stages of retirement because of health costs or long term care and health related expenses that might pop up there. So if you think about it, if you have if you kinda look at it as like a line chart, you can't see it because it's a podcast, but if you think of it like you're drawing a line, it's higher spending rate on the front end of retirement, it goes down over time, the bottom of the smile, then it pops up on the back end of retirement, the other side of the smile. So it's the smiley face. That's why it's called the retirement spending smile.
8:09
And this is a more realistic or more normal spending sequence, if you will. This is what I've seen with many of my clients. As they age, their spending decreases. It's just what happens. You go on the trips, you do the bucket list items, and you're like, I've done all the things I wanna do in terms of the big stuff.
8:24
Now I want to be in my community with my family and enjoy the time I have with them and be productive there. I don't have to travel the world to do that. And by nature, being more local in your community with your family is often cheaper. And I can speak to this from someone who's helped retirees go through this. It's absolutely what happens most of the time.
8:43
Your spending will decrease over time, which ultimately leads to more money at the later stage of retirement. You'll have more money than you ever had if you didn't spend enough during the early stages. So a common issue, a big risk for most retirees is underspending. The problem with the 4% rule is it's adjusting for an inflation rate every single year. It assumes that your spending will increase every single year throughout retirement at a fixed inflation adjustment.
9:11
I would argue things actually work in reverse. You spend more on the front end of retirement and it goes down over time. Okay? So don't look at your retirement plan as a constant increase in expenses over time because that's probably not gonna be accurate. You're likely gonna spend more on the front end.
9:27
Think of this retirement spending smile. Hey, I'm gonna spend more on the front end. It's slowly gonna go down over time and it might go up on the back end, but I have to be able to be flexible here. And that's one of the key components to any sort of retirement distribution plan is being able and willing to slow down or decrease that distribution rate from your portfolio if you ever had to. Let's say we have a 30% pullback in the market.
9:49
Guess what? I'm probably gonna say, hey, is there anything you could cut out for just a little bit while we weather the storm? And so you don't think that just because you know, you do the retirement spending smile and you run the projections and it shows 95% like you're not gonna run out of money. Well, you might have to pull back from time to time because at any given point that sequence of return risk could become a problem and your distribution rate goes from five or 6% to 10 or 11% overnight. And in that situation, we need to be able to pull back on spending, which leads me to the final point I wanna make here.
10:21
I would not start here with the retirement spending. I want you to run your plan with the most conservative estimates, which is what I would say would be the increase for inflation over time. So if you start with a $100 a year is what you need today, increase that to a 103 next year, a 107 the next year, a 110 or 11 the next year, increase it over time and see what that plan projection runs first. Use the inflation adjusted model and that would be the most conservative because again, I don't think people spend in that trajectory or in that way throughout retirement. But if you assume you're gonna spend higher and higher every single year, that would mean if the plan works in that scenario, then it will work in the other scenario where you spend more on the front end and less as you go.
11:05
So I want you to start more conservative, use that 4% rule, use that inflation adjusted spending model and projection, and then work backwards from there by putting into the retirement spending smile. So maybe you see your plan that says 75% based on the inflation adjusted approach or the 4% approach. But then if you go in and you look at the retirement spending smile, which of our software can help evaluate, it says 95%, right? Well, maybe you've got two different numbers to look at. Maybe you're somewhere in the middle of those two things.
11:35
Maybe you're the upper 80s or lower 90s. What this is telling us is that you have variability, you have flexibility, and you can spend more when things are going well. And you can curb that back a little bit when things are not going so well. And it gives you the option. It gives you the power That way you don't have to follow a certain set fixed percentage of how much you must take or can take from your portfolio.
12:00
I want you to understand that you don't have to follow those hard and fast rules. You can actually build a retirement plan that meets your specific needs. Because at the end of the day, what I truly believe about this is that life is for living, not having more money. Right? There's no point to have more money if you haven't lived along the way.
12:17
And guess what? If you end up with a lot more money and you enjoy all the things you wanna enjoy, bonus, right? That's bonus for the kids and grandkids and whoever's behind you. But that is not the main goal. The main goal is to use your hard earned money for the things that you value most and can enjoy the most.
12:30
So hope this helps as you evaluate your retirement distribution and spending plan, and all the different thoughts out there, right? There's so many different methods or way of doing it. What I want you to do is focus on what fits your needs. Don't delay all of your bucket list items into the future because you never know when you might not be able to do them. Take the opportunity while you have the chance, evaluate the plan to see if it's possible and then go for it.
12:52
So I hope this was helpful and if it was, feel free to share it with a friend. Hopefully they can get something from this as well. And if you are an avid listener of the show, you've been enjoying it, I would love a rating and review there on the Apple Podcast app or on Spotify. It helps other people just like you find the show and benefit from these same topics that we're talking about. Thanks so much for tuning into this week's episode.
13:11
We'll talk to you again next week. Hey, it's Jacob again, and I wanted to remind you that nothing discussed in today's episode is meant to be financial, legal, or tax advice. Retirement Answers is for educational purposes only. Thanks for tuning into this week's episode. Look forward to talking with you again next week.