Key Takeaways

• Many retirement plans rely too heavily on outdated rules of thumb like the 4% rule, leading to overly conservative withdrawal strategies that may unnecessarily limit retirees' quality of life.
• Monte Carlo simulations and financial planning models often exaggerate worst-case scenarios, failing to account for market trends and retirees' ability to adjust spending when needed.
• Overly cautious longevity assumptions and rigid spending projections ignore the reality that retirees typically spend less over time and have flexibility in managing their finances.

Retirement planning all too often relies on heavily fixed rules and guidelines that do not take into account the many variables that can affect a retiree’s income and other financial goals. As retirement planning specialists who have worked with hundreds of retirees to help them achieve both the quality of life and sustainability of their portfolio in retirement, we see too many people make unnecessary sacrifices because of strict retirement withdrawal rules. 

Recently, Morningstar published some new research entitled “The State of Retirement Income Report” that claims the old “4% rule” should be changed to 3.7% (as of 2024).  Limited and flawed research that makes sweeping generalizations like this do nothing to help retirees make the best of their retirement.  

Unfortunately, some retirees and financial advisors do not possess the expertise to know this research’s flaws and limitations.  This is why we feel it’s important to address and share our view on why so many retirement withdrawal strategies simply don’t fit the bill and why an initial withdrawal rate, should in fact, be higher than the old 4% rule would suggest. Below are ten reasons we believe most retirement plans and withdrawal strategies are designed too conservatively.

1). Advisors/People Anchor to Rules of Thumb

Rules of thumb, such as the “4% rule” that stemmed from William Bengen’s 1994 research study “Determining Withdrawal Rates Using Historical Data,” have to make too many simplifying assumptions to make the research work.  These simplifying assumptions make the research less meaningful to any one individual.   

The three biggest simplifying assumptions made in Bengen’s study were 1). a 50% stock and 50% bond asset allocation, 2). using only the S&P 500 to represent stocks and intermediate-term U.S. government bonds to represent bonds, and 3). the same amount of income had to be inflation-adjusted and taken from the portfolio for 30 years regardless of how markets performed (i.e., no changes could be made).  

Morningstar’s own research finds that retirees can take a higher starting withdrawal rate and higher lifetime withdrawals by being willing to adjust some of these assumed variables, such as forgoing complete inflation adjustments or implementing some flexible withdrawal systems. 

Morningstar’s research finds retirees who employ variable withdrawal systems based on portfolio performance--taking less in down markets and more in good ones--can significantly enlarge their starting and lifetime withdrawals and would support a nearly 5% starting withdrawal rate.  See our Insight entitled “Dynamic Withdrawal Rules – A Significant Opportunity for Retirement Plan Optimization” for more.

Too many retirees and financial advisors anchor to these rules of thumb because they seem scientific and easy to understand.  Unfortunately, all they do is rob a retiree of higher potential quality of life while living, only to leave money on the table upon passing beyond what was planned.   

2). Limitations of Monte Carlo Simulation Analysis

When creating a retirement income planning strategy, most advisors use tools such as Monte Carlo simulation analysis to calculate the probabilities of success for a given retirement plan.  While Monte Carlo simulation analysis is an incredibly powerful and useful tool, it is not without flaw.  

Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted due to the intervention of random variables. 

The basis of a Monte Carlo simulation is that the probability of varying outcomes cannot be determined because of random variable interference. Therefore, a Monte Carlo simulation focuses on constantly repeating random samples to achieve certain results.  A Monte Carlo simulation takes the variable that has uncertainty and assigns it a random value. The model is then run, and a result is provided. This process is repeated again and again while assigning the variable in question with many different values. Once the simulation is complete, the results are averaged together to provide statistical estimates.

The disconnect is that while markets are not predictable, they are also not completely random either.  If the S&P 500 declined 37%, as it did in 2008 following the great recession, there is not an equal chance of the market suffering a 22% decline the following year like what was experienced at the end of the Internet bubble bursting at the end of 2002.  Yet, this is precisely the type of random scenario that Monte Carlo analysis can pick up as one of its simulated observations.  

Markets that are down are typically followed by a period of positive performance and vice-versa.  This leads Monte Carlo simulation analysis to capture some extreme positive and extreme negative simulated observations that are highly unlikely to occur.  In retirement planning, we only care about those downside scenarios.  By testing a retirement plan based on the bottom 10% of the worst-case scenarios, Monte Carlo analysis likely overestimates the downside possibilities.

(A side note: Monte Carlo simulation analysis is very sensitive to the market return assumptions used.  Some financial advisors and retirement planning specialists set the assumptions to tempered forward-looking return expectations, which could be considered a further layer of conservatism.  On the other hand, some financial advisors and retirement planning specialists set the assumptions to actual historical performance, which may be too aggressive given current stock valuations, bond yields, and economic growth prospects.)  

3). Planning for 90th Percentile Success Rates

Most retirement plans are modeled based on a 90th percentile success rate. What exactly does this mean?  Having a 90th percentile success rate means there is a 10% probability that an adjustment will need to be made somewhere along the way during a 30-year plus retirement to avoid failure based on the underlying assumptions and modeling.  

Unfortunately, when it comes to retirement planning, many misinterpret what the 90th percentile means.  Most interpret this as meaning you have a 10% chance of failing in retirement, which would be very hard to stomach indeed.  If this were true, then I would not want to be more aggressive either.  But because we know that adjustments can be made, especially with proper planning, then planning for a 90th percentile success rate may be too conservative for someone with a long retirement time horizon and the ability to be a little flexible if needed.

4). Probabilities of Success Fail to Capture the Magnitude of Potential Failure

Somewhat connected to #3 above, what exactly does “failure” mean in these retirement planning tools?   Monte Carlo probability-based modeling and measurement makes no differentiation between failing by $1 million or $1.00 or running out of money with ten years to go or one month to go.  

Looking at “failure” as an absolute term rather than a relative term leads many to be more conservative than they might be otherwise.

5). Modeling Ignores That Retirees Can Make Changes

Fortunately, most retirees are not forced to take an unchanging amount of income that must be adjusted for inflation every year from the portfolio for 30 plus years regardless of how markets perform, as the simplifying assumptions made in most research would suggest.  

Being able to forgo an inflation adjustment or reduce spending during adverse investment market conditions can substantially improve one’s range of outcomes.  See our Insight entitled “Dynamic Withdrawal Rules – Higher Withdrawals With Less Risk” for more.

The problem is that only a few financial planning software systems dedicated to retirement planning can model the inclusion of flexible spending or dynamic retirement withdrawal strategies .   The two predominant financial planning software systems used in the industry, Money Guide Pro and eMoney, cannot model flexible spending or dynamic withdrawal rules.  We have already learned how limiting the assumption of not being able to make changes can be when projecting and evaluating possible retirement outcomes.        

6). Modeling Limitations

While, thankfully, there are at least a couple of financial planning software systems that can model flexible spending or dynamic withdrawal rules, there is no system that can even come close to modeling the effect of going to savings or other reserve assets, such as a home equity line of credit, to fund retirement expenditures when markets are down substantially for an extended time.  

Sequence-of-returns risk is the greatest risk a retiree faces, and the ability to manage this risk has tremendous implications on the initial withdrawal rate and portfolio’s longevity.  This is why most good financial advisors recommend some level of cash savings or reserve source of assets that is not correlated with investment markets.

Another limitation of financial planning software systems is their inability to model the benefits of tax efficient withdrawal order sequencing, asset location, tax loss harvesting, and gain harvesting if these tax management strategies are followed.  In their well-known Advisor’s Alpha research, Vanguard estimates that up to 1.85% of annual return equivalent value can be created using these tax management strategies.  Even if only half of this value were realized, it would amount to a significant difference in a retirement plan if it could be modeled. As retirement planning specialists, these are all considerations we keep in mind when helping clients achieve their financial goals. 

7). Conservative Longevity Assumptions

On top of the above, most retirement plans make conservative longevity assumptions. The longevity assumption is a critical driver in retirement planning, and outcomes can be very sensitive to changes in this assumption.

Thrive Retirement Specialists’ retirement planning uses U.S. Social Security Cohort Life Tables for longevity analysis. The cohort life table is based on age-specific probabilities of death, which are calculated using observed deaths (mortality) data from the cohort.  We, like many advisors, target an assumption level that leaves us with  a 10% probability of one spouse being alive.  

If we are planning based on a 90% probability of success, we are planning based on what could happen in the bottom 10% of Monte Carlo scenarios.  Add to this now that we are also planning for the top 10% of longevity scenarios.  So the odds of experiencing both a bottom 10th percentile level of returns and a top 10th percentile level of longevity is 0.01% (0.10% x 0.10%).  Should we really plan based on the most conservative  1% of scenarios, especially given all the other points we’ve discussed?

8). Consumption Tends to Decline in Real Terms

One of the things that most people don’t account for in their retirement income planning is that after considering the effects of inflation, most retirees will spend less as they further progress into retirement.  

J.P. Morgan did a study using the Bureau of Labor Statistics Consumer Expenditures Surveys and found that household spending tends to peak at the age of 45, after which spending declines in all categories but health care and charitable contributions and gifts.  They found that housing remained the largest expense, even at older ages. 

SmartAsset performed a similar study using the same source data and found that spending only increased in 3 of 14 spending categories: Healthcare, cash contributions, and reading.  Further, overall spending declined.  

9). Modeling Ignores Reserve Assets

Most retirement plans are based only on investment-based assets and incomes (from Social Security, pensions, annuities, etc.). They ignore other assets such as home equity, valuable collections, or those old U.S. savings bonds you might have in your drawer.  The greater these other assets, the more aggressive you can be in your retirement planning.  See our Insight entitled “Using ALL Retirement Assets to Maximize your Outcome” for more.

10). Failure to Regularly Update the Retirement Plan

Of all the points made, this one may be the most detrimental and common one that we’ve come across in our decades of serving as retirement planning specialists.  Many retirees and financial advisors treat retirement planning as a one-time, transactional, static exercise and then anchor to the outcome suggested by the retirement plan for a long time.  

Recall that in retirement planning, assumptions are made using the bottom 10th percentile of possible outcomes.  What if a retiree is now 12 years into a 30-year retirement, and none of the bottom 10th percentiles of possible outcomes materialized?  This retiree’s situation has changed dramatically as asset values are now not as low as the plan predicted, and this retiree has a shorter planning time horizon.  This retiree can most likely substantially increase spending or gifting.   

It is good and necessary to plan for downside scenarios when retirement planning, but if those downside scenarios don’t occur, the retirement plan should be updated so that a retiree’s plan can stay optimized throughout retirement.  

Retirement planning should be a dynamic, ongoing exercise, especially for those executing dynamic withdrawal rules and tax management strategies.  During a 30-year plus retirement, variables are bound to change.  Some you will control, but many you will not, such as actual market returns or changes in tax policy.  As soon as these variables change and what once was assumed becomes actual, the retirement plan should be updated so small adjustments can be made along the way, and spending can be increased if those downside scenarios fail to materialize.

The Goal of Retirement Planning and Choosing a Safe Level of Spending

The goal of retirement planning is to develop an optimal strategy to convert retirement assets into sustainable income for however long the retiree lives while not overspending or underspending so the retiree can live a life of maximum contentment and happiness and be free from regret and fear.  

Too much conservatism in retirement planning can lead to the unfortunate unintended consequence of sacrificing quality of life while healthy and living only to pass, leaving a much larger than planned legacy.  A proper balance must be struck so a reasonably conservative retirement plan can be created that uses a safe withdrawal rate while allowing the retiree to live a good quality of life.  

If you would like to learn more about how we can help you craft your optimal retirement plan, you can get your complimentary Thrive Assessment and schedule a  call with one of our retirement planning specialists here.