Some rules are meant to be broken
Originally published on: June 10, 2016
Ever heard of the “80/20 rule”? It began as a simple observation by economist Vilfredo Pareto that 20% of the people owned 80% of the land(in 19th century Italy). When he noticed that 20% of the peapods in his garden also produced 80% of the peas, he thought he was on to something. The idea grew into the Pareto Principle, a rule of thumb in economics that loosely applies a power law relationship to describe how things of value are often unequally distributed.
Over time this rule began to be applied more broadly. 80% of your profits come from 20% of your customers. 80% of your problems come from a different 20%. 20% of your software contains 80% of your errors. 20% of a city’s criminals cause 80% of its crimes. 20% of a given group of cats require 80% of the available attention. And so on.
There’s an eerie sort of near-accuracy to these ‘rules’ that makes them quite plausible. Cats are like that, right? But statistically most of them are not much more than convenient nonsense. All they’re really good for is a reminder that the distribution of almost anything tends to draw a curve, not a line.
The “4% rule” has a similar history. The basic idea is that you can safely take out up to 4% of your retirement savings every year. It began way back in 1994 with a research study of how hypothetical withdrawal rates by financial planner William Bengen. This was based on all kinds of very specific assumptions: a stock-heavy fixed portfolio, a range of historical periods starting in 1926, and crucially, a retirement of exactly 30 years. It also came in closer to 4.5%.
Regardless, 4%-per-year has become the go-to advice for financial planners and their clients. Never mind that some people retire early, live longer, or both. That you may choose to work in retirement. That in real life people vary their spending for many reasons, from big expenses like health care to gut feelings about the economy. That Social Security, annuities, and other income sources may be involved. Or that everyone’s portfolio is different, and different from what was typical 30 years ago. Not to mention the disquieting sense that globalized financial markets just don’t behave the way they used to.
So what’s this rule good for? Not a lot. If there were no alternative, it would still be useful as a starting point. But today’s financial technology makes it possible to customize your spending plan to match your situation, goals, plans, fears, and resources. It’s not perfect, and given the unpredictability of life it never will be. But given the choice, we’ll take a sophisticated, proven algorithm over a single, magic number any day. We think a lot more than 80% of retirement investors would agree.
Image courtesy Antti T. Nisseinen via Flickr Creative Commons