One Statistician’s Warning for Retirees About the 4% Rule

On this episode of The Long View, my guest was Stefan Sharkansky, a Ph.D. statistician who specializes in finance. He developed a website called The Best Third, designed to help people with their retirement spending plans and portfolio structures. We talked about bequests, Treasury Inflation-Protected Securities ladders versus annuities, and his formula that balances secure income with flexible spending.

Here are a few excerpts from my conversation with Stefan, who wrote “The Only Other Spending Rule Article You Will Ever Need.”

Why the 4% Rule Can Lead to Underspending

Christine Benz: In the paper [“The Only Other Spending Rule Article You Will Ever Need”], which was published in the Financial Analyst Journal, you talk about the kind of research shortcut that many have used in Bill Bengen’s seminal research that starts with that 4% guideline. But you, in the paper, are quite critical of those fixed-rate spending systems because they lead to underspending, sometimes dramatically so. So, people deprive themselves, effectively, during their retirement periods. Can you talk about that?

Stefan Sharkansky: Absolutely. First of all, Bill Bengen and the 4% rule deserve a lot of credit because it was the first systematic approach for spending down a retirement portfolio, really. But it has come under criticism from a number of researchers and thought leaders over the years for a few reasons. And one is because, whether it’s 4% or whatever the fixed rate happens to be, people’s spending and tax situations during retirement aren’t really constant. So, having a constant withdrawal rate doesn’t really fit the way people actually need to spend.

And another part of it is, as you mentioned, the underspending. And I found in researching the paper and running through the numbers with historical scenario data is that, in a median market scenario, if you follow the 4% rule, you would end up, your 30-year retirement plan, with half again as much wealth as you started with, adjusted for inflation. What that means is you are not spending as much as you could, and you are leaving so much on the table for your heirs that you’re not able to enjoy the quality of life in retirement that you can truly afford.

The Case for Spending More and Giving Earlier

Benz: Our research very much corroborates that same finding, that those fixed real withdrawal systems—and we use Monte Carlo simulations, but they oftentimes lead to very large leftover balances. And I sometimes hear from retirees who say, “Well, I’m not too worried about that because I have children, grandchildren,” but it does seem like, at a minimum, people are losing some opportunities for lifetime giving, right?

Sharkansky: Absolutely. And I’m a big believer in the concept of “give with a warm hand, if you can.” That is, make your gifts to charity and to your family members while you’re still alive instead of waiting until the end of your life.

A Retirement Income Strategy Using a TIPS Ladder

Benz: Me, too. And also, the data shows that people, when they inherit money from their [parents], are often in their late 50s, early 60s. Their financial fortunes are pretty well set by that life stage. I want to delve into your research, which builds on some research from Larry Siegel, who’s previously been a guest on this podcast, as well as M. Barton Waring. And it’s called ARVA, the system that Siegel and Waring discussed in their paper, or annually recalculated virtual annuity. Can you discuss what ARVA is?

Sharkansky: It uses the word “annuity,” and it tries to provide the main benefits of an annuity, a steady and more or less predictable income stream while you’re alive. And it contains two parts. One is a ladder of TIPS, Treasury Inflation-Protected Securities, which provides a level of secure guaranteed income, the closest thing to riskless guaranteed income that we have in the investment markets. Along with, in the case of my paper, I’d included a stock portfolio, where the withdrawals from the stock portfolio are amortized, and we can get into that details a little bit later, but it’s a formula for withdrawing from the stock portfolio in such a way that you’re mathematically guaranteed that you will not run out of money, but the withdrawals from the stock portfolio will vary with market performance. You take a larger withdrawal when the market’s done well and a smaller withdrawal when the market has lagged a bit.

Valentina Djeljosevic contributed to this article.