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Michael Finke, a professor for the American College of Financial Services

Retirement Planning > Spending in Retirement > Income Planning

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

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What You Need to Know

  • Advising clients on crafting a reliable income stream for their retirement involves a growing list of investment options and spending considerations.
  • The work of researcher Michael Finke and others shows diligence and flexibility in retirement spending are fundamental to success.
  • He says retirees should consider the full suite of tools available to them — and not eschew annuities in the process, especially when rates are this high.

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.

“To me, the most problematic element here is that you aren’t responding to new information about what has happened to your portfolio and also any changes in your expected longevity,” he explained.

The Role of Guarantees

Pensions used to be much more common, Finke notes, and it’s useful to consider what this same $40,000 in spending would look like were it to be guaranteed rather than being subject to market and longevity risk.

“Would the person who is spending out of their private $1 million portfolio spend the same as the person with the guaranteed income?” Finke asked. “The economists will tell you no — the one who has the guaranteed income for life is going to spend more because they aren’t facing the same risk of running out of funds very late in life.”

Clients spending from their own portfolio, if they experience excess longevity or a rough run in the markets, could see their accounts dwindling as they enter their 90s, and that could force some dramatic and unfortunate spending cuts at a vulnerable time.

“So, this naturally inspires people to spend less to avoid that risk, and that is rational, because you are facing that idiosyncratic risk and you can’t know how long you are going to live,” Finke said.

“With all else being equal with respect to the wealth projected, you see the ones with pension income spend significantly more in retirement, because they don’t face that same idiosyncratic longevity risk,” he noted.

This extends into the topic of lifetime income insurance and what advisors need to know about it, Finke says.

“You can consider effectively buying insurance against this risk — against the risk of having to cut back below a certain amount of spending in retirement,” Finke says. “It’s known as a lifetime income benefit, and generally it will come along on a fixed annuity or a variable annuity.”

With a variable annuity, generally the guarantee will be lower, and it is relatively expensive to provide that lifetime income insurance regardless of the specific vehicle, Finke says.

“It costs about 1.5% for a given insurance company to be able to provide this expected benefit, according to the academic research,” he pointed out.

“What is the expected benefit? If you run out of money in your investment account, the insurance company will then reach into their general account portfolio and continue to make those income payments. So, you could really talk about that 1.5% not really as a fee but as a premium for coverage,” Finke explained.

More Options for Tackling Longevity Risk

Finke says there are other important pathways to consider to address these questions.

“As an economist, one of my favorites is delaying Social Security,” Finke said. “It allows you to build up your base of inflation-protected income for life. In my research, I have found that, for most higher-income individuals who can expect to live longer than the average American, they can expect to meaningfully increase their overall retirement wealth by delaying Social Security.”

Finke, who says this move is a “no brainer,” plans to do so in his own retirement.

“The other thing I plan to do in my own retirement is buy insurance to protect myself against outliving my savings,” Finke said. “For example, you can get a tax-favored insurance policy of this nature through what is known as a qualified longevity annuity contract or QLAC.”

With a QLAC, clients can take up to $200,000 of their tax-deferred savings and buy an annuity that will kick in with income starting at age 85.

“At today’s interest rates it’s incredibly attractive to buy one of these policies,” Finke said.

Finke suggests that clients can also use deferred income annuities purchased during the accumulation phase.

“You can get rates of returns that are comparable to what you earn on corporate bonds these days,” Finke said. “And there are tax benefits associated here too, so it’s again one of those under-utilized and under-appreciated strategies if your goal is to get income in a tax-efficient manner.”

Pictured: Michael Finke


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