In October of 1994, the Journal of Financial Planning featured an article that would come to be known as one of the most important, often-referenced, and highly debated topics in financial planning.
At its core, the article provided us with something precious. It gave us a very simple, easy to follow a guideline that virtually anyone can use when thinking about retirement.
It was the birth of what has since become “The 4 Percent Rule”.
Bengen and the Origin of the 4 Percent Rule (1994)
When William P (or Bill) Bengen wrote his now famous article “Determining Withdrawal Rates Using Historical Data”, he didn’t set out to revolutionize the way we planned for retirement. All he wanted us to do was help us understand that sequence of returns risk was a very real problem when we’re planning for retirement, and offer a better solution.
After demonstrating the dangers of basing a retirement plan on average returns, Bengen presents the reader with a series of data sets designed to do one thing: Find the greatest amount of money that you could safely withdraw from your nest egg without any fear of depleting your funds.
As a former aeronautical engineer turned financial planner, he used a very data-driven and analytic approach to solving this problem. It was both brilliant and creative!
How the 4 Percent Rule Was Established
To find the optimal withdrawal rate, Bengen back-tested various withdrawal rates against something called “rolling periods” of market data.
To illustrate how this would work, the first simulation would start with a retiree in 1926. The calculation would find how many years it would take until the entire portfolio ran out of money. Then he’d do the same thing for 1927, 1928, … and so on all the way up to 1976.
It’s important to note that Bengen didn’t just look at market returns. He also factored inflation rates for each year into the equation as well. He knew that the combination of both factors would have a profound net effect on the end result.
Bengen ran the simulation multiple times using withdrawal rates ranging from 1 to 8 percent and using different stocks and bonds ratios. As you might guess, lower rates lasted for a long time while higher rates lasted only a few years.
Any guesses which rate he decided was optimal?
The take-away from Bengen’s article was straightforward and straight-forward:
A retiree with a portfolio of 50% common stocks and 50% intermediate term treasury bonds could successfully withdraw 4.0% from the starting balance of their portfolio, and then continue to do so with an inflation adjustment for a minimum of 33 years.
Hence, the “4 percent rule” was born.
So how exactly does this work? Let’s say you retired with a portfolio of $1 million dollars:
- First year: You could withdraw $40,000.
- Second year: You would take out the same amount as the year before and adjust for inflation (example 3%): $41,200.
- Third year: You would again take out the same amount as the previous year and adjust for inflation (example 3%): $42,436.
- And so on.
Some rolling periods, an inflation-adjusted withdrawal rate of 4.0% worked great for over 50 years! But since we wanted a “safe” number that used to work for every rolling period (no matter what the sequence of returns was), Bengen choose 4.0 percent as the optimal figure.
(If you’d like, you can read the entire article for yourself here. I would suggest looking through the graphs!)
But That’s Not All!
Although the 4 percent rule was the main conclusion from Bengen’s famous article, there were plenty of other useful discoveries that his research revealed.
For example, it may interest you to know that:
- Withdrawal rates of 3.0 and 3.5% with the same inflation adjustment sequence worked for over 50 years in every data set! (Early retirement seekers, take note!)
- Asset allocation was a significant influence. Increasing your portfolio to 75% stocks and 25% bonds increased most periods to last 50 years or more. But the minimum time dropped by one year to 32 years of success.
- Portfolios with stocks below 50% or above 75% were counter-productive; meaning these retirees would have run out of money sooner than 30 years.
- If you had a secondary goal of ending your retirement with the largest portfolio possible (to perhaps leaving to heirs), the higher stock allocation of 75% was the most beneficial.
At last! Someone had finally offered a way to deal with a sequence of returns risk, and with tangible data to back it up.
But it wasn’t until years later the 4 percent rule actually gained in popularity.
The Trinity Study (1998)
In February of 1998, the AAII (American Association of Individual Investors) Journal published another important milestone for the 4 percent rule.
Three professors of finance from the Department of Business Administration, Trinity University, San Antonio, Texas, Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz, had decided to conduct their own study of safe withdrawal rates.
Their approach would be almost identical to Bengen’s; using the same “rolling-periods” method that he had previously used. However, rather than focus on how many years your money would last 100% of the time for a given withdrawal rate, the authors instead developed statistical probability rates for a matrix of fixed withdrawal rates (3 to 12%) and time-frame periods (15 to 30 years).
Their paper was dubbed “The Trinity Study”, and you can read it for yourself at this link here. Again, the table of results they developed is well worth taking a look at.
The Trinity Study Makes Similar Conclusions to Bengen
The take-away from the Trinity Study was very similar to Bengen’s:
A retiree with a portfolio of 50% stocks and 50% bonds will have a 95% chance of success of not running out of money for at least 30 years if they start making withdrawals at a rate of 4.0% and increase those withdraws with inflation every year thereafter.
More Gold Nuggets of Info
In addition to validating Bengen’s earlier claim, the Trinity Study also made the following other valuable points:
- The analysis was conducted with both inflation adjusted and non-inflation adjusted returns. Even though we know that a safe withdrawal rate of 4.0% works with inflation adjustment, it was also found that a rate as high as 6.0% could be used if you DIDN’T adjust for inflation every year with a 95% chance of success for 30 years or more. (More on this point later …)
- If you bumped up your stock allocation to 75%, your chances for 30 years of success jumped up from 95% to 98%.
- Similar to Bengen, portfolios with stock allocations below 50% or above 75% were counter-productive.
- Also similar to Bengen, the authors concluded that a portfolio of stocks closer to 75% would leave you with more money at the end of retirement.
(A quick technical note: If you’re wondering why Bengen’s 4% rate worked for 33 years and the Trinity Study’s 4.0% rate only worked 95% of the time for 30 years, the difference was in the investments they used. Both Bengen and the Trinity Study used the Standard & Poor’s 500 index for stocks. But when it came to bonds, Bengen used intermediate treasury bonds while the Trinity Study used long-term, high-grade corporate bonds.)
With the “magic number” in mind, it is clear that you aren’t going to get that number by keeping your annuity. It makes more sense to do an annuity cash out than to keep an investment which, when compared to the rate of inflation, is going down in value each year. Again, the financial world had more validation to suggest that the 4 percent rule was the magic number to use!