Is The 4% Rule Dead?
In what might have been Gil Weinrich's final SA for FAs podcast, he knocked it out of the park in exploring the idea of being able to realize when you have enough money for your financial objective and what you should do if that occurs. This might seem like a departure from posts recently about financial fragility but the connection between having enough money and financial fragility is that the solutions don't have to involve being wealthy. The solution can be about living below your means and creating optionality such that you don't need a couple of million bucks in your IRA.
The key to understanding whether you might have enough is to understand what you actually need versus what you might want. For this discussion we will use the example of someone who is 50 years old, makes $100,000 and plans on taking Social Security at age 67. Let's further assume this person lives a $50,000 lifestyle and has $500,000 saved for retirement. At $100,000 income, his SS benefit would be $2454 in today's dollars and if his wife takes the spousal benefit at the same time, she'd get $1227 so their total would be $3681/mo or $44,172 for the year which leaves them $6000 away from replacing 100% of their spending need. Assuming a 4% withdrawal rate their portfolio needs to be $150,000 and they have $500,000. They might need less than $50,000/yr depending on their mortgage situation.
If they derisk entirely and put the whole kitty into a fixed income product(s) that yields 2% then compounded, the $500,000 would grow to $700,120 when they are 67 and ready to retire. Assuming nothing goes wrong, these folks are well ahead of the game. My example is of course simplistic and the assumption that nothing goes wrong is a big one but it paints a good picture for people who have substantial savings for how to assess the need for risk in their portfolio and while the idea of completely derisking is not what I would suggest, they might not need to have 60% in risk assets (60% meaning 60% in equities like in a 60/40 portfolio).
The obvious things that can wrong include some sort of extraordinarily expensive event, something medical perhaps, price inflation that gets away from us (might be hard to see at this point but is still a risk) or something else that forces a lifestyle change that could not reasonably be foreseen.
If instead of 60% in risk assets they have 30% or $150,000, assuming a very reasonable 12% annualized, that's a poke at Suze Orman, let's assume 6% annualized (is that too much?) then the $150,000 grows to $403,000 by the time they are 67 and the $350,000 annualizing at 2% grows to $490,000 for a total of $893,000. If something horrible happens with the risk tranche, they still have $490,000 in the very low risk bucket plus whatever is left over from the bad luck with their risk bucket, still ahead of the game even if not as far ahead as they's like.
To flip the coin, the sacred 4% withdrawal rate may not be so sacred. The backtesting that concluded 4.3% as the optimal rate was based in part on investment grade interest rates that no longer exist. They might come back of course but that is tough to see now. Earlier in the post I used an example of a 2% interest rate. Even that might be tough to come by safely. A 30 year US Treasury yields 1.27%. A ten year yields 0.65%. If you build a 60/40 portfolio and are looking for a "safe" 4% withdrawal rate, you get almost none of your 4% from any treasuries you own. There are plenty of fixed income and fixed income-ish exposures you can take on that will give you 3-4% but you will take risk of some sort to get it. It might be credit risk, risk of volatility like if you buy a closed end fund and so on.
Should people instead plan around a 3% withdrawal rate? That's one way to go. Three is certainly safer than four, of course zero is the safest but most people will need to take something. The 4% rule is actually 4% of your balance when you start and then adjusting it for inflation. I've never seen or heard of anyone adjusting their withdrawal rate by the rate of inflation. Someone starts taking...say... $3000/mo and that amount works for some period of time and then something might change, something small or something major and they adjust accordingly.
A slightly different way to come at is something we've discussed many times before which is no matter what you have; 4% or more specifically no more than 4%. Really it would probably be more like 1% every three months. If you're getting by on $8000/quarter, so you have $800,000 total, and then a year like 2019 comes along and you're up a lot, maybe 12% and you're knocking on the door of $900,000 you could take $9000 out per quarter. If you don't need the extra $1000 though, don't take it. Who knows how 2020 will end up but it would make sense to bank that "extra" $1000 and maybe some of the gain from $800,000 up to $900,000 for years where the market is weak.
Another way to mitigate the risk that might go with a 4% withdrawal rate would be to put a couple of years worth of expenses into cash. If on January 1st you looked at your account and saw you had all expected expenses for 2020 and 2021 in cash already, the last couple of months could have been much easier to endure. This makes it much easier to avoid selling in fear because you're concerned about expenses.
There will be years where a portfolio comes in way ahead of 4% and well under. The natural lumpiness of returns requires work in terms of setting some aside in the fat years but it helps improve the chances that 4% remains sustainable.
I am of the belief that in all aspects of life, the more effort you put into something the better the results will be. Putting in the work to learn how not to panic, to learn how to be disciplined, to be flexible and to be adaptive increases the odds of success. No one will care more about your outcomes than you.