Solving the 4% Rule

How to adapt the 4% rule to meet your needs.

The Wall Street Journal posted a generally negative article about the 4% retirement rule and the general state of people's ability to retire. The 4% rule was derived by William Bengen in the 1990's. The short version is that a 4% annual withdrawal rate from your portfolio in retirement has a better than 90% chance of being sustainable such that you don't run out of money.

This has become a crucial building block for all retirement planning. Really it is a starting point for retirement planning. If you need 5% or 6% then your odds for success go down. It's not that you can't take more, you simply need to understand the risk of doing so. If you start out in retirement with $1 million, taking 6% and in your second year of retirement there is a 2008-like event then it should be obvious that your odds of running out of money early go up if you're sticking with a $60,000 withdrawal.

If you study it, you will find that the 4% rule includes increasing the withdrawal by inflation every year. A simplistic example; if you start in year 1 taking $40,000 and inflation then is 2% you'd increase you're withdrawal by 2% or $800. This makes no sense to me. What if inflation is 2% but the equity market drops 40% and you have a 60% weighting to equities? In that scenario, the withdrawal could be insanely high.

The way I have framed this is; whatever you got, 4%. If you have $1 million; $40,000. If the next year the market goes up and you have $1.1 million; $44,000. Back down, take less. You can always take less, or spend less of course like setting that extra $4000 aside in case the market drops in year three. The drawback is the potential lack of predictability but what I think whatever you got 4% does is helps you better withstand large financial shocks that come along every so often. We are going to need a new roof in the next few years. At the low end that is a four figure proposition. What if your hand is forced with something that big, or bigger at the same time the stock market cuts in half?

Another point I have made is that while you may have a "retirement number" you are working toward, your reality will be whatever you end up with. If you think your number is $800,000 and you end up at $750,000, you're probably not in serious trouble but if you're at one half or one third of where you think you need to be then something will have to give but either way, whatever you end up with is your reality (repeated for emphasis).

The follow on here then is what do you do if you're in a situation where something has to give? Spending less money one way or another becomes one answer along with downsizing into a smaller house, working longer or taking up a new (part time?) vocation that might be more fun. Working backwards with the 4% rule, a $15,000 part time job equates to an additional $375,00 in portfolio savings.

Conceptually, if you are not where you need to be then you have an obstacle to overcome and it is something that can be overcome, you just need to figure some things out.

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