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The 4% rule—Three Cautions

The 4% rule—Three Cautions

You’ve heard the rule of the thumb—you can safely spend 4% of your total savings amount at retirement each year of retirement, plus an annual markup for inflation, and you won’t outlive your money. That’s $40,000/year if you have $1 million saved, plus 3% for inflation added each year. This is the core of the systematic withdrawal retirement income strategy.

This strategy works best as a way to draw from an upside portfolio once you have covered your essential annual expenses with low-risk and guaranteed income—from Social Security, pensions, cash, CDs, high quality bond ladder, and simple income annuities. For those who have their income floor well-covered, here are three cautions to keep in mind if you want to use the 4% rule as part of your retirement income strategy.

Caution #1: Stay Invested In A 60/40 Portfolio
The old 4% rule assumes your savings are invested in a 60/40 stock/bond portfolio and growing at an annualized rate of about 7%. That’s how a 1/25th slice of your savings (ie, 4%) can be made to last for 30 years, with 3% added each year for inflation—the pie gets a little bigger each year even as you slice off another piece.

But if you aren’t holding your savings in a 60/40 portfolio, properly allocated to achieve the projected 7% historical annualized average, then your savings may not grow enough and you could run out of money. Many retirees have difficulty staying 60% invested in stocks, and do not have a balanced, risk adjusted portfolio. Seniors typically de-risk by reducing their allocation to stocks. And many own just a few individual stocks—the company they worked for, or maybe a handful of large-cap dividend companies. This is a risky base for a 4% withdrawal strategy.

The Vanguard LifeStrategy Moderate Growth Fund (VSMGX) is an example of balanced, risk-adjusted portfolio suitable for a sustainable withdrawal strategy. It’s a straightforward fund, a balance of three Vanguard index funds, about 40% total US stock market, 40% total US bond market, and 20% international stock index. The fund holds thousands of global stocks and domestic bonds, diversifying away the risks of owning individual securities.

Systematic withdrawal is based on holding a portfolio constructed like this throughout retirement, and selling a chunk of it every year to fund your annual expenses.

Caution #2: Withdraw Less—3% is the new 4%
Even if you hold your savings in VSMGX, some researchers have recently argued that the old 4% rule has turned into the new 2.5% or 3% rule.

Backtesting with historical returns shows that you can stretch a 4% twenty-five-year straight-line draw to thirty years with annual inflation adjustments. The researchers, however, believe those historical returns are a historical anomaly, reflecting the tremendous growth of the US economy after WW2.

Those days are behind us, they say. In today’s low-yield climate, they project at least a decade of lower returns between 4% – 5%, based on the current historic low-yield of the 10-year Treasury bond and TIPS (inflation adjusted Treasury bonds) that pay negative real interest (‘real’ means after adjusting for inflation). In other words, you literally can’t bank on a 60/40 balanced portfolio to sustain a 4% withdrawal rate for 30 years.

If a safe withdrawal rate today is more like 2.5% to 3% instead of 4%, you need to have significantly more savings to sustain the same level of income that the old 4% rule produced—33% to 60% more savings. That’s $1,333,333 to $1,600,000 instead of a mere $1,000,000. Which brings us to…

Caution #3: Systematic Withdrawal Works Best for the Well-Funded
As we noted here recently, the more you have saved and invested, the safer systematic withdrawal is as a retirement income strategy.

Simple math really. The smaller your savings, the smaller amount you can take each year, and the shorter the amount of time it will last.

The old 4% rule meant that at retirement, you needed 25x the amount of your essential annual expenses not covered by Social Security, pension, and guaranteed income, for the roof over your head, food on the table, clothes, health insurance, and transportation.

In the current low-yield world, where market returns might barely keep up with inflation, the new 3% rule means you need 33x your uncovered essential annual expenses. The sooner you start, the more you save, and the more sensibly you invest, the easier the retirement puzzle will be for you to solve.

The 2.5%, 3%, or 4% rule (pick one based on your best estimate about future economic growth!) is a handy way to gauge your progress as your career evolves. Do the math, and you can match up your savings and your potential annual expenses to see if your savings are on track. Are you saving at a rate that will get you to 25x-30x the amount you need for uncovered essential annual expenses?

When you get into you 50s, you should go to the next step. The simple math of the 4% rule may no longer suffice. You should develop a more detailed retirement income plan that matches your resources and expenses with your household lifestyle and timeline. Such a plan will allow you to adjust your savings, investments, and expenses to better align with your household balance sheet, while there is still time to make a significant difference.

Since everyone’s balance sheet is different, there’s no ‘rule of the thumb’ that can substitute for good planning.

If you have any questions or comments or if I can be of assistance, please feel free to contact me via email or phone, anytime.

—Michael Lonier, RMA℠

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