Much discussed but seldom fully understood, the 4% rule has been around for decades and is often the gold standard in rule-of-thumb guidelines. However, the 4% rule was designed at time when our children’s college costs were relatively smaller and more predictable. In today’s world, the idea of planning for your retirement must be thought of in conjunction with the unknown costs of college funding and in the end the 4% rule doesn’t quite add up.
Like most stories, we should start at the beginning. The 4% rule (actually 4.20%) came out of one straightforward question: How much can I withdraw in retirement before I run out of money? While simple on its face, the question proved very hard to answer. But a man by the name of William Bengen had the academic chops to do it. (For more, see: How to Think About College as an Investment.)
When everyone had pensions there was not a strong need for a withdrawal rate rule of thumb. But now that we must build our own retirement nest egg, it is critical.
The core of Bengen’s findings was that no matter what day you retired on during the studied timeframe of 75 years (starting in 1926), if you withdrew 4% of the starting balance at the beginning of a 30-year retirement with a 50% stocks and a 50% bond portfolio, you would not run out of money before the end of the period. You would not outlive your money.
The 4% amount was increased for inflation each year. So if you started with $1 million at retirement with a 3% inflation, you could take $40,000 ($1 million x 0.04) in year one, $41,200 in year two, $42,436 in year and so on. The biggest mistake that retirees and advisors make is they take out 4% of the account balance each year. That is a recipe for disaster. One good year in the stock market and you would take out too much and in a bad year, you might starve.
Bengen’s 4% rate was the rate that worked even when you started on the worst possible date to retire. Given that most people don’t retire on the worst possible day, the 4% was arguably too low for most retirees. The 4% rule was built around some very bad markets.
Another reason the 4% might have been too low for many is it assumes no change in spending. We are all able to make adjustments when needed. We are a resilient and adaptable people.
The 4% Rule Today
But that was then and this is now. There are many reasons to be concerned that the 4% rule is too low: (For more, see: Why The 4% Rule No Longer Works For Retirees.)
- People are living longer.
- Healthcare is more expensive and long-term care is a much greater tail risk.
- Paying for college right before retirement.
Our focus today is on the latter paying for college. If you have college funding behind you, then you have less to worry about. But if you don’t, then you might need to take a look at one or more of the variables you are using to plan your awesome retirement, especially the 4% rule.
When Bengen did his study the cost of college relative to almost everything else was more manageable. Now we face a paradigm shift of sorts. Paying an extra few hundred thousand for college for just two to three kids can make planning for the 4% rule more difficult.
Let’s look at an example:
Mr. and Mrs. Dotherighthing have calculated that they need $1 million based on the 4% rule to retire at age 65. As we talked about, this would give them $40,000 of income to supplement Social Security and pensions. But with tuition, fees and room and board increasing at over 3x normal inflation (according to the 2015 College Board study) over the last 30 years, college is a larger burden on income and saving.
Mr. and Mrs. Dotherighting live in Minnesota and all four of their kids will attend the University of Minnesota Twin Cities Campus. The stated yearly cost is over $26,000 per year. The Dotherightings have decided to fund $25,000 of each child’s college education. This will give them almost a year of education paid for by mom and dad. This means a decrease in retirement savings of $100,000. If you throw in the possible loss of investment return, the total decrease in a nest egg could easily be $200,000, assuming at least 10 years of growth at a 7% return. (For more, see: The True Cost of Attending College.)
This means that instead of $1 million for retirement, the Dotherightings now have $800,000. They would have had to budget more for education funding and either assume a lower withdrawal rate or a higher base amount when they were calculating how much they would need to get to their $40,000. One of the most difficult things about college funding is not knowing the cost. If the Dotherightings planned too much for expenses, they would not enjoy the time leading up to retirement too.
College is institutionalized into our society. So when its cost explodes relative to normal inflation, every financial rule of thumb goes out the window.
We don’t know what our amazing wonderful kids will decide on or how much it will cost. The problem with the unexpected is we can’t plan for it and given we could be paying college tuition well into our 50s, there is little time to make up for the difference. If it happened at age 35, its impact might be different.
The introduction of the 4% rule was well timed. It came out in the mid 90s, a time when we were moving from pensions to 401(k)s and more of retirement funding was the retiree’s responsibility. But times have changed. We have new variables and the 4% rule cannot be the only rule you follow.
Retirement is too important to mess up and as Bengen himself said, “Go to a qualified advisor and sit down and pay for that. You are planning for a long period of time. If you make an error early in the process, you may not recover. ” (For more, see: Avoid These Retirement Portfolio Mistakes.)