Safety-First vs. a Probability-Based Approach

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Up until now, everything that we’ve been talking about with “safe” withdrawal rates comes from something called the “probability-based” school of thought for retirement income planning.

To put this in context, for every withdrawal rate we’ve analyzed, there is always a rate of success associated with it.  There is some inherent element of a “gamble”; even if it’s very small.

The safety-first school of thought takes a different approach.  First and foremost, it puts the goal and certainty of retirement income before all else.  Period!

A safety-first approach is not concerned with reaching retirement as quickly as possible, having the most retirement income possible, or even building the most amount of wealth.  Its primary purpose is singular:

To find a way to ensure that the money you need for your basic essentials and contingencies are met under all circumstances!

Secondary priorities such as leaving money behind to heirs or wealth growth are held to a much lower priority; or in some cases dismissed altogether.  These would be considered discretionary or legacy priorities, and are far behind the first two.

Because there can be no risk, it is not acceptable to use a variable asset source to generate income.  Translation: A retirement nest egg based on market returns is far too risky!  In the safety-first approach, there is no such thing as a safe withdrawal rate.  To truly have 100% certainty, the income source must be guaranteed.

The safety-first school of thought is not something new.  It has been around since the 1920’s with the research of people like Frank Ramsey and Irving Fisher. In recent years, one of the bigger advocates for the safety-first approach is financial researcher Dr. Wade Pfau.  You can learn more about a safety first approach at these posts here.

  1. What is a Safety First Retirement Plan?
  2. Two Philosophies of Retirement Income Planning

Could the 4 Percent Rule Be Unsafe?

Is there any truth to the 4 percent rule or a probability-based approach being flawed?

Unfortunately, going forward, there may be some chance for uncertainty.

As Dr. Wade Pfau put it in the NY Times:

Because interest rates are so low now, while stock markets are also very highly valued, we are in uncharted waters in terms of the conditions at the start of retirement and knowing whether the 4 percent rule can work in those cases.

FYI: Here’s a chart of the Federal Interest rate over time.  As you can see (over on the highlighted area in the right), they’ve been at a historic low for quite some time.

Dr Pfau was also part of a paper from 2013 in the Journal of Financial Planning with co-authors Michael Finke and David M. Blanchett called “The 4 Percent Rule Is Not Safe in a Low-Yield World.”  In it, they warn that if current bond returns don’t spring back to their historical average until ten years from now, up to 32% of nest eggs would evaporate early.

Of course, these points are only a matter of opinion since the future always remains uncertain.

In support of a traditional probability based method, Michael Kitces argues that:

The 4 percent rule was built around some rather horrific bear markets of the past already.  Do we necessarily know or expect that the next one will be so much worse than any of the other terrible historical bear markets we’ve seen?