## Trend Check with Tushar Chande

# Re-optimizing the 4 Percent Rule (Initial Withdrawal Rate) for Low Inflation

This post is for retirees or those near retirement. All of you will have to make some decisions on how to manage withdrawals from your retirement portfolio. The Bengen 4 Percent Rule is the industry standard, which states that an initial withdrawal rate of 4 percent of starting capital, adjusted for inflation each year, will be a "safe rate" that will "ensure" that you will "not run out of money" over a 30-year retirement horizon. Naturally, the higher the "safe" withdrawal rate, the larger your spending budget, the "better off" you will be.

**Key Planning Variables**

There are many variables and assumptions that go into retirement planning. Here are just a few: your initial capital, your spending patterns and needs, and your planning horizon. The planning horizon is usually 30 years from life expectancy tables, but that of course depends on your individual situation. Ultimately, you will have to prioritize consumption versus longevity.

**Two Key Concepts behind 4% Rule**

There are two key concepts behind the initial withdrawal rate calculation: inflation adjustment and historical simulations.

First, the goal is to maintain your buying power by adjusting the initial withdrawal by the inflation rate. So, if inflation were 3 percent at the end of the first year, the amount used in the second year is increased by 3 percent. Hence, this method is also called the constant dollar method, because the purchasing power is "constant". (The inflation rate is assumed to be a positive number, so the initial withdrawal amount never decreases.)

Second, historical data on inflation, and stock and bond returns in the US are used to simulate many initial withdrawal rates till one finds the "highest" initial withdrawal rate on historical data for any starting point that meets some ending portfolio size constraint over the chosen time horizon. Since the actual rates of inflation, and stock and bond returns and actual post-retirement lifetime experienced by any one retiree are unknowable, the brute force historical simulation merely offers an idealized solution that may turn out to be too aggressive or too conservative for any particular retiree.

**An Example of 4% Rule Calculations**

The historical simulations require many assumptions that I will not discuss due to space constraints. (You can review the references below for the details.) However, here is the basic result underpinning the 4 percent rule (see Chart 1). The Y-axis plots the initial withdrawal rate for various portfolio combinations that pass the survival filter over a 30-year simulation. The simulation shows that for most portfolios, the initial rate approaches or exceeds 4% on historical data, giving us reasonable confidence that an initial 4% withdrawal rate will be "successful" for most retirees. Remember that this initial withdrawal amount increases by inflation each year.

*Chart 1: This historical simulation shows that most stock and bond portfolios would "last" 30 years for an initial withdrawal rate near or above 4 percent adjusted for inflation.*

**Sensitivity of Simulation to Historical Inflation Rates**

The simulation is very sensitive to inflation rates in historical data, particularly the high inflation observed in the 1970's and early 1980's. In effect, the simulation assumes that every retiree will see that level of inflation in their lifetimes, and effectively drives down the initial withdrawal rates. As we know, inflation rates today are well below those observed in the above time period. How can we calibrate the sensitivity of the historical simulation to the high rates of inflation? One way is to replace the historical "high" inflation rates with an arbitrary value, say 3%, which is the long run inflation rate in the US. Any change in the simulated safe initial withdrawal rate will then allow us to measure the sensitivity of the simulations to historical data. (For details, see here).

*Chart 2: The initial withdrawal rate could be about 100-basis points or 1% greater if the period of high inflation in the 1970's and 80's is "removed" from the simulation. Thus, the simulation is sensitive to assumed inflation rates, and initial withdrawal rates could be higher in an era of low inflation than suggested by the traditional calculations using high inflation periods in historical data.*

My simulation shows that initial withdrawal rates could be 1% higher in a low-inflation environment and still meet the "survival" threshold on historical simulations. Thus, the simulations for the initial withdrawal rate are very sensitive to historical inflation data, and could be "too conservative" for the current low inflation period.

**Simulations are Not Perfect**

As with any simulation, these simulations are not perfect, and we have to make many assumptions, some of which may not occur within the lifetime of a present day retiree. Thus, this result should be used with caution, and is largely intended to allow you to explore alternatives with your financial planner or adviser.

Many alternative paths to planning withdrawal strategies are available, and the little book referenced below is an easy read to give you some food for thought.

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**References**

1. Chande: researchgate.net/publication/320623749_Re-optimizing_the_4_Percent_Rule_to_Adjust_for_Low_Inflation

2. Chande: Financial Plans for Successful Wealth Management in Retirement

An Easy Guide to Selecting Portfolio Withdrawal Strategies (ISBN 978-1-4834-5696-6)