For those planning on retirement, it’s a common notion that the 4% rule is a wise way to plan for future spending. This rule, created by financial advisor William Bengen, suggests withdrawing 4% of your portfolio in the first year of retirement, adjusting for inflation each year after. But financial advisors Paul Vladem, Executive Chairman, and Luana Mobley Corral, CFP®, CFS®, CLTC®, BFA™, of Associated Financial Consultants and Investor Services (AFC-AIS) discussed the downsides to this rule and why no retiree should hold it steadfast.
One major factor advisors weigh is a client's risk tolerance. Corral explained the Nitrogen Program that she uses to test this.
“The Nitrogen Program is a stress test used to see how clients react to market crashes like 2008 or COVID,” she said. “From there, I’ll build their portfolio around their score.”
Artificial Intelligence, Corral said, can help generate a risk tolerance score, but it doesn’t know the clients like a financial advisor does. In one case, Corral was working on a client’s retirement portfolio who, in most respects, was on the more conservative side when it came to investing her money. When her score came back in the high 90s, signaling that she was extremely risk-tolerant, Corral knew something didn’t add up.
“I knew my client. I knew this wasn’t like her. Turned out, there were other factors at play when she was taking the test, which explained her score.”
Then, when the client retested, she scored more moderately. For Corral, this highlighted why human advisors rather than algorithms should manage client assets. Had the original score gone unquestioned, an automated system might have steered the client toward riskier holdings, all because AI doesn’t know its clients the way that people do.
This circles back to the limits of the 4% rule: there are always more nuances that can’t simply be managed with a steadfast rule. It’s crucial to consider any extenuating circumstances, whether it’s risk tolerance, health conditions, or family elements.
Vladem said that these aspects are just as important as risk assessment itself.
“The difference between a financial advisor and the 4% rule is that the advisor understands the client’s goals and objectives,” Vladem said. “Do they want to leave money to their kids? Do they like to spend? How do they react to market fluctuations?”
All of these factors shape how a retirement account should be managed, something that the 4% rule doesn’t account for enough.
What’s even more cumbersome to weigh is the sequence-of-returns risk. In other words, if the market goes down early in retirement, you must sell more shares to generate the same amount of income. This permanently diminishes your principal and is nearly impossible to recover in future years.
So, how do our financial advisors mitigate this risk?
“The best way to protect your client is not withdraw too much at the beginning,” Vladem said. That way, if the market becomes bearish, the client can still recover. “You must always consider the ramifications of the loss years.”
Asked about the biggest mistake that clients make when planning their retirement, Corral said that it often has little to do with money, but everything to do with purpose. While having a financial plan is necessary for a seamless retirement, oftentimes, people do not consider what they’re going to do during retirement.
“People generally need to have a reason and purpose to get out of bed in the morning,” Corral said. Whether that’s through volunteer work, a creative project, or trying new hobbies, retirement may prove to be difficult for those who are accustomed to having a steady routine for their day. That’s where our financial advisors come in; not only offering monetary insight, but helping to navigate the human side of the transition as well.