Todd Tresidder has written a super article about the evolution of our understanding of how safe withdrawal rates work at his Financial Mentor site. It is called Are Safe Withdrawal Rates Really Safe?
Juicy Excerpt #1: It is known as the “4% Rule”, and it is widely considered to be “the truth” in safe withdrawal rates for retirement. The problem is it’s not the truth and every day people risk a lifetime of retirement savings on it.
Juicy Excerpt #2: It is the single most important question I get from retirees and near retirees. The reason is because safe withdrawal rates impact every aspect of retirement planning — from the lifestyle you can afford to the amount of savings needed to fund it. Small errors in safe withdrawal rates multiply over many years causing huge financial impacts.
Juicy Excerpt #3: The key point defining all 2nd Generation research is that each study applies the same basic premises thus producing extraordinarily consistent results. This consistency caused the 4% Rule to become conventional wisdom and be mistaken as “truth” when it is really just a product of the research premises.
Juicy Excerpt #4: To understand the problems with 2nd Generation research we need look no further than the amazing breadth of dubious assumptions behind the results.
Juicy Excerpt #5: Rob Bennett was an early pioneer in 3rd Generation modeling by advocating (through various online forums) that withdrawal rates must be adjusted for market valuations consistent with research by Cambell and Shiller (1998). Also, Wade Pfau (2010-2011) broke new ground by applying safe withdrawal rates to international market data with shocking results. He also applied valuation, interest rate, and inflation metrics in regression analysis to form a dynamic and robust safe withdrawal rate model. The key point illustrated by 3rd Generation research is that a deeper level of complexity underlies the sacred cow “truth” known as the 4% rule. It was the best answer for its day, but those days are gone. It is a second generation model whose shortcomings have been proven well enough that it must be retired.
Juicy Excerpt #6: This problem is why 2nd Generation models chose to define the highest withdrawal rate that could survive all historical data periods. The assumption was the best and worst performing periods could not be determined in advance so the only safe choice was the lowest common denominator that survived all time periods. Fortunately, that assumption is false. Future investment returns are not “luck” or random as many would guess. As it turns out, market valuations at the time you begin your investment holding period are inversely correlated to the return you can expect over the following 10-15 years.
Juicy Excerpt #7: The reason I focused on the 2nd Generation model is because it has been elevated to the status of “truth” in the financial planning industry. The 4% Rule is quoted regularly in the financial media and used as a benchmark by which all other retirement planning models are compared. The problem is it’s not really safe. The 4% rule could cause you to leave a fortune on the table or run out of money long before you die. The 4% rule is a static conclusion in a world that is dynamically evolving. In summary, there are specific assumptions built into the research supporting the 4% model that must be seriously questioned.