The Fundamental Problem with the 4% Rule for Early Retirement Isn’t the 4% Rule

The 4 percent safe withdrawal rate, short-handed as the “4% rule” is the cornerstone of most discussions about retirement planning, along with its inverse, “25x” (the idea that you need to save roughly 25 times your annual spending, and then you’re good to retire forever on that spending level).

The 4 percent rule has been discussed and debated so much that we can all practically recite the details of the study that brought us the rule, right?

Trinity study… 75% equities, 25% bonds… Spend 4% of your investable asset portfolio each year (not your total net worth)… 30-year time horizon… Monte Carlo simulations… 100% rate of backward-looking success… 

Of course there are other analyses that show lower rates of success over the same period, arguing for the 3% rule instead if we hope to get something close to a guarantee that we won’t outlive our money. And there are the endless debates about what “spending 4 percent” actually means, how inflation factors in, etc. This will go on forever.

But here’s the thing about the whole discussion: Debating whether it should be the 4% rule, the 3.5% rule, the 3 percent rule — heck, the 1 % rule — all of it misses the point.

It especially misses the point for early retirees, who have much more than a 30-year horizon, if we’re all lucky — perhaps several decades more. The 4 percent rule is likely sound mathematically, as explained eloquently by Michael Kitces on a recent Mad Fientist podcast, and it could very well hold into the future, despite dire predictions about future economic growth and market gains.

The specific percent isn’t the issue. Any percent isn’t the issue.

The fundamental problem with any “safe” withdrawal rate is the underlying assumption of level spending over time. 

And you don’t have to be planning for dirtbag years followed by larger-living years, as we are, to be looking ahead to increasing costs in the future. You could be the most disciplined budgeter of all time and still need to plan for your spending to change over time.

Let’s take a look at why.

This is the start of a series that will explore Social Security and Medicare in the context of early retirement. Today’s post dips a toe into the subjects, but we’ll jump all the way in next week. 

Let’s talk about spending level in terms of a “basket,” the same way the Bureau of Labor Statistics talks about the “basket of goods” that define the consumer price index. Let’s assume we all want to live a lifestyle that feels about the same year to year — living in the same home or in similar-style homes, being able to eat the same types of food year to year, being able to travel and spend on entertainment similarly, buying about the same amount of stuff.

The idea of level spending over time assumes that, if the markets return historical averages, then the 4 percent rule or [insert your chosen safe withdrawal rate here] will beat inflation and allow you to keep living a comparable lifestyle year after year, keeping everything in your lifestyle basket the same.

Which could be true, except for three hugely important factors:

• Several big categories of expenses increase in cost higher than the rate of inflation,
• Social Security and many public and private pensions don’t keep up with the rate of inflation, and
• Health care costs while on Medicare are much higher than most people anticipate

Let’s break those down.

Many Costs Increase Faster Than Inflation

It’s not one or two expense categories that tend to beat inflation, and we’re not talking about outpacing inflation by a percent or two. We’re talking about sometimes massive discrepancies between the rate at which your money will grow and the cost of essential needs, eroding your purchasing power over time, and depleting what’s in your basket if you assume level spending. Let’s look at the biggest costs that outpace inflation. (And for reference, over the past two decades, inflation has averaged out to 2 percent a year, which is normal in a historical context.)

Health care — Health care is top of the list, both because it has outpaced inflation for more than a decade, and because it is a major and unavoidable expenditure for all of us. While health care cost increases have moderated in recent years, they are still expected to increase by 6 to 7 percent a year for the foreseeable future (triple the projected rate of inflation), and that’s not counting the large bumps in premiums many states will see in 2018 to account for the uncertainty that Congress has introduced by refusing to act to stabilize the insurance markets. And future legislative changes could possibly worsen the rate of increase, particularly if the Affordable Care Act provision limiting insurance company profits is removed.

Medication — Specifically within health care, medication costs are skyrocketing across the board. AARP breaks this down in greater detail, noting many drugs that have doubled or tripled in price. And overall, drug prices increased 10 percent from 2015 to 2016 while overall inflation was only 1 percent that year.

Gas — Gas prices have been low in the past few years, but historically, they have outpaced inflation, at times by a large margin. In general, all energy costs tend to be more volatile, and fossil fuel-based energy sources will hit their inevitable decline in production at some point in the not-too-distant future, making the cost of travel, heating and cooling, and electricity hard to predict long term. And remember that higher gas prices trickle down to everything that relies on gas to get to you, like groceries.

Housing, in Some Places — Real estate and rental market trends are highly local, so we can’t make the same sweeping generalizations here that we can in other categories. Over the long term, housing tends to hew fairly close to inflation, but that’s not necessarily true year to year, and it’s absolutely not true in every market. Across the country, housing costs increased 4 percent annually over the last decade, which is double the rate of inflation over that period, and in some outlier markets like Boston and San Francisco, the rate was even above 6 percent annually.

Education — It’s no wonder so many would-be early retiree parents wait until their kids are out of college to pull the ripcord. College costs have gotten out of hand, and there’s no sign of slowing anytime soon. Over the past decade, public colleges increased on average 6 percent a year, while the rate for already more expensive private collages was 5 percent annually.

Entertainment — You may not care about paying for cable TV, or going to Disneyland (the two examples CNN Money calls out), but entertainment costs across the board tend to increase as fast as the market will bear, which is often well above inflation levels, often topping 5 percent or more annually. If you plan to be entertained in the future, it’s worth bearing this in mind. (And for you movie popcorn lovers, the inflation is even higher for you — above 6 percent.)

Social Security and Pension Benefits Don’t Keep Up with Real World Inflation

Not everyone plans on relying on Social Security or a pension in retirement (more on this coming soon!), but for those who do, it’s important not to see that future benefit as equating to a fixed spending level. First, public and private pensions are getting reduced left and right, and second, Social Security benefits will be overhauled at some point in the next decade or so, which could change how the benefits are calculated. But the bigger deal is how poorly both can potentially track against inflation.

Social Security, by law, receives cost of living increases (COLAs) that are pegged to the BLS’s consumer price index (CPI). However, in practice, those increases are often not enough to guard against purchasing power erosion because, many argue, the BLS is looking at the wrong index, and should instead be looking at the CPI for the elderly (CPI-E), a more specific measure that has tended to have higher inflation because of higher Medicare and prescription drug costs, among other factors. So even though Social Security has that protection built in, in reality is doesn’t function as intended, and many seniors find their “basket” shrinking each year.

Medicare Still Comes With Massive Out-of-Pocket Costs

Medicare costs vary enormously with age and health status, of course, but one thing that is consistent is that most Medicare recipients tend to underestimate what their out-of-pocket costs will be under the program. The average Medicare recipient spent almost $5,000 out-of-pocket in 2010 (ages ago in terms of health care costs), an alarming figure considering that half of Medicare recipients have an income under $24,000 a year (in 2010 dollars). I’ve seen varying figures, but data show that most people on Medicare will still spend tens of thousands of dollars — perhaps hundreds of thousands of dollars — on out-of-pocket premiums and medical expenses, making Medicare not quite the cost insulator that some may imagine it to be.

Plus All Those X-Factors…

Then there’s the stuff like long-term care that I’ve written about before, and which could quickly erode anyone’s carefully stockpiled portfolio. And all the unknown unknowns we can’t plan for at all.

Why This Hits Early Retirees Especially Hard

Over a longer time horizon, the magnitude of unknown unknowns increases. And while it might be slightly more realistic to think that someone who’s 65 might have more sense of what their future expenses might be than someone who’s 40 would, there’s still huge variability in both scenarios. But stretch out that timeline and you magnify everything.

The health care unknowns alone should be enough to make all of us pad our portfolios for our later years, but it’s not only health care that should have us all thinking that level spending over the long term just may not be realistic.

Building a Multi-Phase Plan That Works for You

We have a detailed two-phase plan that is aimed toward at least doubling our spending when we reach age 60, but not everyone needs a plan like ours. What matters is that you build in some way of accounting for potential cost increases over time so that you can maintain that comparable basket from year to year. Perhaps it’s building a projection that assumes your spending will increase a few percent each year on top of inflation. Perhaps it’s adjusting your withdrawal rate to account for increasing costs above and beyond inflation. Perhaps it’s going full-on two phase like we have. It’s up to you to find the solution that best suits your needs and circumstances.

How Are You Thinking About Costs Over the Long Term? Want to Debate the 4% Rule? It’s All Fair Game!

Alright guys, let’s dig into all of this in the comments! Are you planning for level spending over the long term, or do you have a plan for dealing with increased costs over time? Think the 4% rule is plenty safe with level spending and want to fight about it? ;-) (Just kidding — we’re all friends here.) Whatever your thoughts, whether it’s on spending or projections or any of it, let’s discuss!