Bob C., a friend of the channel, asked us, “Isn’t the 4% rule a bit antiquated? Does it still matter?”. Thank you, Bob, for the inspiration for this post, we hope this answers your questions. (If you have your own questions, please contact us at algorithmicfire@gmail.com we’re happy to do the work so you don’t have to.)
Newer Strategies
The 4% Rule is a specific method implementing a Safe Withdrawal Rate (SWR), more generally called a withdrawal strategy. Since its inception, alternatives have gained popularity.
- In 2006, the author of the 4% rule changed his recommendation to 4.5%. (Reference: 1)
There are three general types of withdrawal strategies that are widely discussed:
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Fixed Withdrawal Strategies (FWS) - the 4% rule is one of these. The withdrawal rate is fixed when you start your withdrawals, only updated for inflation. (“Fixed” refers to the fact that the withdrawal rate is fixed in terms of real dollars; or dollars of constant purchasing power. The withdrawals are allowed annual inflation adjustment.)
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Pros - You know your income, it doesn’t change.
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Cons - As we discussed in our post “Does Using a Safe Withdrawal Rate Mean I Likely Die With No Money?“, this approach risks accumulating a large savings balance.
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Percent of Portfolio Strategy (PPS): This strategy is simple; you take a fixed percent of the portfolio each year.
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Pros - It is better at avoiding accumulation of wealth.
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Cons - There is a significant chance of having income substantially lower than initially planned. This can be mitigated by adding a floor for the withdrawal amount.
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Variable Withdrawal Strategies (VWS) - These build on the FWS and PPS by adding rules to allow changes in withdrawal rate; there are many variations. Commonly, they have your withdrawal rate increase or decrease in proportion to the investment return, capped at some amount each year. The changes in withdrawal rate may only occur if your actual withdrawal rate has gone above/below a “guardrail”.
- Pros/Cons - This method is really just a more extreme version of PPS, and its Pros/Cons are similarly more extreme.
Other Strategy Considerations
The original 4% Rule prescribed a portfolio of 50% stocks and 50% intermediate-term U.S. government bonds. More modern strategies are less prescriptive in both investment options, as well as model inputs like withdrawal rate.
Rate of failure is another input. The original 4% rule was based around a 0% failure rate assumption. Many modern methods are satisfied with much higher failure rates; read results carefully.
Types of Analysis
Before moving on, it is important to mention that when analyzing withdrawal strategies, there are two common methods:
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Backtesting - (A.K.A Historical analysis) This method of analysis uses actual historical investment return data as the inputs to simulations to model effectiveness of any given withdrawal strategy.
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Pros - You can model how a given strategy would have actually performed in the past, against difficult periods like the Great Depression and Great Financial Crisis.
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Cons - There is very limited data. That, and people question how relevant data from the early 1900s is, as markets and regulatory requirements have changed greatly since then.
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Monte Carlo - (A.K.A. statistical modeling) The core idea, named after the famous casino in Monaco due to its reliance on chance, is to run a model hundreds- or thousands-of-times, each time using different random values for the unknown variables (investment returns).
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Pros - You can quickly model 1000s of unique scenarios.
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Cons - It is not real data. It doesn’t answer the specific question “what if I had been using this prior to the Great Financial Crisis?”.
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Thus, when you are presented with results from models of withdrawal strategies, you have got to understand: withdrawal strategy, type of analysis, failure criteria, and investment strategy used. All will impact the results.
Wait, Three General Types of Withdrawal Strategies?
The three withdrawal strategies previously listed are all actually variations on a single algorithm. That single algorithm can be defined:
- Pick a withdrawal rate used to determine withdrawals for the first period; periods will generally be one year.
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Choose to allow the amount of withdrawals to be modified, or not.
- If the withdrawalal amount is not modified, this is FWS, otherwise it is PPS/VWS.
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If the withdrawalal amount modification is enabled:
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Each year, a percentage of the investment return is used to modify your withdrawal rate.
- The withdrawal rate modification may only occur if the actual withdrawal rate has crossed some high/low thresholds. These thresholds may be the same value, in which case withdrawal rate adjustments happen every period.
- The change in withdrawal rate may be limited to a maximum positive or negative value.
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With that algorithm:
- Fixed Withdrawal Strategies (FWS) - disables the investment return modifier, and thus the withdrawal rate caps are irrelevant.
- Percent of Portfolio Strategy (PPS): sets the percent of investment return withdrawal rate modifier at 0, and no caps on withdrawal rate changes.
- Variable Withdrawal Strategies (VWS): sets the percent of investment return withdrawal rate modifier and caps. I.E. investment return withdrawal: 50%, positive cap: 5%, negative cap: 2.5%.
All of these seemingly different withdrawal strategies are really the same algorithm, with different input variables.
Performance of FWS vs. PPS vs. VWS
Below, we will analyze the three strategies.
Important modeling detail: With variable withdrawal strategies, your income may be reduced considerably. For the purpose of this post, we have limited variable strategies such that no withdrawal will be less than 90% of the initial withdrawal.
Full modeling details are at the end of the post.
Chart Description
For each model we will show the same two charts:
- Balance Trajectories - these plots show the account balance for each of the 500 runs; failing runs are shown in red.
- Distribution of All Annual Withdrawal Amounts - These plots are box plots showing the range of withdrawals that occurred in all 500 of the runs; distributions are shown for failing runs, passing runs, and all runs.
- SWR is shown at the top of each plot; for PPS and VWS this is just the starting withdrawal rate, which is changing during the simulation.
Fixed Withdrawal Strategy (FWS)
Key observations:
- There were 8 failures; success rate = 98.4%.
- The withdrawals are a constant value: $50K every year.
- The account value at the end of the simulation is frequently well over $2M, the range is: $0 - $6,093,122.
Percent of Portfolio Strategy (PPS)
Key observations:
- There was one failure; success rate = 99.8%.
- The median annual withdrawal increased from $50K to $53K; there are some withdrawals well over $160K.
- The bottom quartile of withdrawals is between $45K-$48K; less than the initial withdrawal of $50K.
- The final balance range has been greatly reduced to $0 - $3,290,417.
Variable Withdrawal Strategy (VWS)
Key observations:
- There was one failure; success rate = 99.8%.
- The median annual withdrawal increased to $62K, from $50K (FWS) and $53K (PPS); there are some withdrawals over $200K.
- The bottom quartile of withdrawals is between $45K-$51K; less than the initial withdrawal of $50K.
- Triggering the failure was just barely avoided in several cases.
- The final balance range has been further reduced to $0 - $1,213,253.
Takeaways
- The models are not as different as they appear, and can generally be reduced to one algorithm.
- Fixed withdrawal strategies have the advantage of a fixed income amount, at the expense of a possible large range of final account balance.
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Variable withdrawal strategies (PPS and VWS) will, on average, allow you to live off of a higher income AND reduce the range of final account balance, but there is a significant chance you will need to live off of less income than initially planned for some period. (Minimum withdrawal amount was fixed at 90% of the initial withdrawal in this model).
- Since the alternative to a 5% VWS, with similar success rate, is a 4.5% FWS, VWS seems like a clear winner; start higher, if it doesn’t work, cut back to the income an FWS would have provided.
The King Is Dead! Long Live The King!
So the 4(.5)% Rule may be dead, but the thing that replaced it is pretty much the same thing; the differences are values of the inputs to the models, portfolio selection, and what you consider failure.
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The 4(.5)% Rule is still a great starting point for determining if you are nearing being financially ready to retire.
- Note that all the cases modeled in this post started with a 5.0% withdrawal rate, because higher withdrawal rates increase failure rates.
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If failure is income below what you initially determined, the 4(.5)% rule still works well.
- If failure is passing with a very high account balance, and you are comfortable with possibly living off less than initially planned, then a variable strategy will suit you better.
Also consider a mixture of strategies. I.E. start with FWS to guarantee income early in retirement. Then if you do see your balance accumulate significantly later in retirement, switch to a variable strategy where, even if you wind up on a “reduced income” path, your income is still acceptable.
Model Details
We wanted to get straight to model results, but here are details on the modeling for those interested.
General model inputs:
- The model is a Monte Carlo simulation with 500 runs, where each run models one 30 year retirement based on random samples of investment returns matching the designated portfolio.
- Portfolio of 50% stocks and 50% investment grade corporate bonds.
- The account starts with $1M.
- Retirement lasts 30 years.
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Failure is if the withdrawal amount goes below 75% of the initial withdrawal amount, or the account balance drops below 5% of the initial balance.
- Failure criteria is probably what differentiates these models the most. With FWS, all that matters is the account doesn’t run out of money. With variable strategies, you may not run out of money, but you also may not be happy with substantially reduced income.
Model specific inputs:
- FWS - 5.0% withdrawal rate based on initial portfolio value; I.E. withdrawals are always $50K every year.
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PPS - 5.0% withdrawal rate based on actual account value.
- Withdrawals amounts are variable but limited to at least $45K (90% of the initial withdrawal amount).
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VWS - 5.0% initial withdrawal rate. Each year the half of the investment return value is used to adjust the withdrawal rate for the next year. (I.E. if there is a 8% investment return, the withdrawal rate is increased 4%. Similar for negative returns.)
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Withdrawal amount changes are capped at +5%/-2.5%
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Withdrawals amounts are variable but limited to at least $45K (90% of the initial withdrawal amount).
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Algorithm Description
- Starting withdrawal rate of 4.5%.
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Each year that your investment return is positive, your withdrawal rate increases 50% of the investment return gain up to a maximum of 5% change in withdrawal rate.
- I.E. your investments have a real return of 10%, your withdrawal rate is allowed to increase 5% (50% of the 10% investment return). In this case, that increase in withdrawal rate is the maximum allowed.
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Similarly, if investment return is negative, your withdrawal rate decreases by 50% of the (negative) return and is capped at a 2.5% reduction.
- (The above caps are picked to try to allow you to enjoy gains, while not reducing income too far from the initial plan.)
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For Educational Purposes Only: All content on this site, including articles, tools, and simulations, is for informational and educational purposes only. It should not be construed as financial, investment, legal, or tax advice. The information provided is general in nature and not tailored to any individual's specific circumstances.
Software Development Has Inherent Risks: The software used to perform the analyses may have errors or inaccuracies. When we post updates to any material, errors or inaccuracies that are subsequently fixed may change the results.
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View Video Transcript
You know, for decades, the 4% rule has been the golden rule of retirement. But what if I told you it's not just outdated? What if it's actually costing you money? Yeah. We're going to dig into the numbers and see if there's a smarter way to plan for your future. You know, this whole thing actually kicked off because of a fantastic question from one of you, Bob C. He asked, "Isn't the 4% rule a bit antiquated? Does it still matter?" And Bob, that question is, "It's perfect. It really gets right to the heart of how much retirement planning has changed." All right, so before we can talk about where we're going, we really need to get on the same page about where we've been. So, let's do a quick refresher on the classic 4% rule. The whole idea is, well, it's beautifully simple, right? You take your nest egg, let's say it's a million bucks. You pull out 4%. So, that's $40,000 in year 1. Then, every single year after that, you just take out that same amount plus a little extra for inflation. That's it. This is what we call a fixed withdrawal strategy or FWS for short. And you can see the appeal, right? It's a predictable, stable paycheck year in and year out. But, and this is the big butt, this is what gets people like Bob asking those great questions. The problem is it's so conservative that you often end up with a huge pile of money after 30 years. Money you could have been spending and enjoying all along. Okay, so if that fixed strategy is just too rigid, what else is there? Well, this is where things get really, really interesting. So, let's meet the challengers. First up, you've got the percent of portfolio strategy. We'll call it PPS. Instead of a fixed dollar amount, you just take a fixed percentage, say 5% of whatever your portfolio is worth that year. So, if the market's up, you spend more. Simple. Then there's the variable withdrawal strategy or VWs. Now, this one's even more dynamic. It lets your paycheck go up and down with your investment returns, but and this is key, it has some safety rails built. Okay, so FWS, PPS, VWS. It sounds like three totally different ways of thinking, right? One's super rigid, the others are flexible. But what if I told you they're not really different at all? That they're basically just three settings on the exact same machine. And this really breaks it down perfectly. Look, every single strategy starts at step one. You pick your withdrawal rate. Then step two, you decide if that amount can change over time. The old school 4% rule, the FWS, just says nope and stops right there. End of story. But the other two, PPS and VWS, they say, "Yep," and they just add one more step. Step three, where you set the rules for how it changes. See, they're all part of the same family. Okay, so they're all related, but how do they actually stack up against each other in the real world? Let's run the numbers and find out. To do this, we're going to use something called a Monte Carlo simulation. It sounds fancy, but it's really just a computer model that lets us simulate hundreds of different possible futures for the stock market. We're going to run 500 different 30-year retirements, all starting with a cool million bucks. This will show us the whole spectrum of what could happen. And just to keep things fair, we're going to start all three strategies with a 5% withdrawal rate. All right, first up to bat, the classic, the fixed withdrawal strategy. We're taking out 50 grand in year 1 and just adjusting for inflation after that. Let's see how it does. Let's break down these results. On the left, that's your portfolio balance over 30 years for all 500 simulations. See those eight red lines at the very bottom? Those are the failures, the times where the money ran out completely. Now, look over to the right. That's your income. It's a perfectly flat line at $50,000. Predictable, right? But here's the kicker. Look back at the left chart. See that massive spread in how much money is left over? So many of these simulations end with millions of dollars still in the bank. All right, contender number two, the percent of portfolio strategy. Now, remember with this one, we're taking out 5% of whatever the balance is that year. Not a fixed dollar amount. Let's see what that does to the charts. Whoa. Okay, two things pop out right away. First, look at that portfolio chart on the left. The failure rate, it dropped from eight down to just one. That is a massive improvement. But there's always a butt, right? Look at the withdrawal chart on the right. It's not a flat line anymore. Your income now bounces around with the market. And you can see in some cases it actually dips below that starting 50,000. And that brings us to our final strategy, the most dynamic of the bunch, the variable withdrawal strategy. This one actually adjusts how much you take out based on how the market did last year. So check this out. Just like the last one, only one failure out of 500 runs. So it's just as safe. But look at that income chart on the right. The median withdrawal, what the typical person gets, jumps to over $62,000 a year. That's like giving yourself a massive pay raise in retirement. Now, the price you pay for that is even more volatility. Your income can swing around quite a bit. But look at the final balances on the left. They're all clustered much more tightly together. No huge leftover fortunes. Okay, let's put it all side by side. This table really just makes the whole thing crystal clear. The fixed strategy FWS, it has the lowest success rate, but you get that perfectly stable income. The other two, PPS and especially VWs, they crank up your success rate and your median income, but you give up that stability. And just look at that final balance range for VWs. It's so much smaller. It basically ensures you're not going to accidentally leave a massive unspent fortune on the table. So, after all that data, the big question is what does this actually mean for you? Which of these paths is the right one? When you get right down to it, it all boils down to one single crucial trade-off. Stability versus potential. Are you willing to let your income bounce around a bit for the very real chance at a much wealthier retirement? Because on average, these variable strategies mean you get to spend more money. The only catch is you have to be cool with some years being a little leaner than others. And hey, remember that key detail from our simulation? We put a floor on those variable strategies. We programmed it so your income could never drop below 90% of what you started with. So never below $45,000. Having that safety net, well, it makes the whole idea of a variable income a lot less terrifying, doesn't it? So let's go back to the beginning. Is the 4% rule dead? You know, I'd say no. It's not dead. It's just bendy trout. It's no longer the only rule in town. Think of it now as the starting point, the baseline that you can use to compare these other more dynamic and let's be honest, probably more rewarding strategies. And that leaves us with one final question. And this one isn't about spreadsheets or computer simulations. It's about you. What do you value more? Is the peace of mind that comes with a perfectly predictable paycheck worth potentially leaving millions of dollars on the table? Or are you willing to ride the waves of the market for a shot at a much, much wealthier retirement? That choice is all yours.