Ask the Retirement Expert: Michael Finke on Rethinking the 4% Rule

Advising clients on the best ways to build and maintain the right income stream for their retirement involves both a growing list of investment options and the reconsideration of some long-held industry assumptions.

Michael Finke, a professor of wealth management for The American College of Financial Services and its Frank M. Engle Distinguished Chair in Economic Security, says that helping retirees determine what level of spending in retirement is “safe” has become a red-hot topic in the evolving world of wealth management.

Finke makes that case in the first episode of ThinkAdvisor’s podcast series Ask the Retirement Expert. He credits the rethinking of the long-favored 4% withdrawal rule to a variety of interrelated causes — some demographic, some regarding product innovations and others involving research and significant changes in the advisory profession itself.

As Finke emphasized, advisors are being called upon to help clients protect their retirement income given the risk that they might outlive their savings and could experience negative portfolio returns late in their working lives or early in retirement.

Ultimately, Finke warned, advisors who fail to provide adequate answers to these questions — and who fail to contextualize income planning with discussions about investment management, tax mitigation and legacy planning — will surely find their practices losing ground.

The 4% Problem

As Finke notes, the 4% safe withdrawal rule is perhaps the most famous example of what is called a “fixed withdrawal rule.”

“In other words, you have a portfolio and at the moment you retire, you calculate a fixed withdrawal amount based on this percentage,” Finke explained.

So, on a $1 million portfolio, a client could expect to safely withdraw $40,000 per year, adjusted for inflation, and never run out of money.

“This is all based on an analysis that showed that, if you look at historical returns in the United States over the long term for a balanced portfolio, you should reliably be able to spend this much without depleting the portfolio in a 30-year retirement,” Finke said.

That original paper backing the 4% rule was written in the early 1990s, Finke points out, and since that time, there have been some big changes in the marketplace that make this 4% rule “no longer the standard of a safe withdrawal rate that it used to be.”

“This is something we addressed [almost 10 years ago] in the research that I did with David Blanchett and Wade Pfau,” Finke said. “We point out that, in a lower-return environment like the one it is reasonable to expect we may be in for the coming decades, that is no longer necessarily a safe withdrawal rate.”

Simply put, the United States enjoyed a strong period for returns in the 20th century that was used as the basis for that research, Finke says, and it may no longer be valid going forward.

“There’s also the fact that we are seeing longevity increasing over the data baked into the 4% withdrawal rule, and that is especially true for the top 10% of income earners here in the U.S.,” Finke warned.

“We have seen six additional years of longevity for men in just the last two decades. That’s an amazing improvement in longevity, but it also means some of the standards that went into the 4% withdrawal rule research no longer hold today,” he said.

As Finke points out, for a healthy couple retiring at 65 today, some 50% of them will see at least one spouse live beyond 95 — the maximum age considered in the original 4% rule research.

The Difficulty of Sequence Risk

Finke also addresses the “arbitrariness” and “big exposure” to sequence of returns risk.

“The real degree of safety with the rule depends a lot on when you retire and whether you get unlucky or not,” he said.

As Finke explains, an advisor can have two client couples who have made the same preparations for retirement, but if one couple had retired on Jan. 1, 2022, and ran that 4% analysis, they would face a very different outlook relative to the second couple who had waited until June 1, 2022, to retire.

Making the 4% projection in January would have suggested a safe spending level of $40,000 per year, Finke says, whereas the same analysis run in June would give a “safe” figure of $32,000.

“If you think about it, this doesn’t make any sense, because that second couple actually has more money relative to the first couple, because the first couple would have been spending out of the portfolio even as it fell with the market,” Finke suggested.