Financial Planning Methodology (I): Debunking the “4% Rule” and Other Retirement Planning Myths

by Aleksandr S. Seleznev, MBA, CFP®, CFA, Senior Advisor & Portfolio Strategist

This is the first in a forthcoming series of blog posts related to retirement planning. 

When a client already has a retirement plan—or a financial plan, I’ll use the phrases interchangeably—one of the most important questions to ask is:  How secure is it? Unless the client has a clear understanding of their income and expenses in retirement, it could be challenging to address that question.

There are many popular rules of thumb, which our team tends to discuss with clients because we don’t always feel they're appropriate and sometimes, they may even be dangerous for planning purposes. 

One of the most common rules of thumb is the “4% rule”. To use a figurative example for how this might apply, a 65-year-old client with a $1,000,000 portfolio wants to make sure their money will last for the next 30 years. According to the 4% rule, the client would take out 4% from their portfolio each year. Then, each year the client would adjust the amount for inflation with an objective of not running out by age 95. 

This is a very well documented process supported by research. However, this doesn't take into account a client’s actual tax situation. If a client has different types of accounts (such as tax-deferred IRAs, tax-free Roth IRAs, and taxable brokerage accounts), it is also important to ensure adjustments are being made based on the tax implications of withdrawing from these accounts. 

Another factor to gauge, especially in times of significant market volatility, is the comfort level of a client taking out a fixed amount from their portfolio.

Another popular rule of thumb is based on an equation. That is, when a client decides to subtract his or her age from 100 and use the difference to determine the allocation that should be put into stocks. Someone generated this concept and the idea caught on with other people making retirement planning decisions. But the approach raises many issues. To use another figurative example, let's say a 60-year-old client subtracts his age from 100, which comes out, according to this method, to 40% that would be invested in stocks. If the client is not retiring for another 10-15 years, that still leaves a significant part of the portfolio in investments that would not earn all that much. So this is not an effective strategy for a lot of people. 

Magazines and articles offer plenty of conventional wisdom or well-documented ideas that suggest how much a client should have based on some geographic considerations. And the thinking behind it may be fine, but if final decision-making isn't adjusted to an individual’s specific circumstances, the idea can be incomplete and, ultimately, not as successful as the client would like it to be. 

So, what does our team believe is a better way of approaching this? We will cover that in the second part of this series. 

Contact Judith Barnhard, senior advisor at MBI, for more information.