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Retirement's 4% Rule Should be a Guide Not a Rule
January 20, 2022

Retirement's 4% Rule Should be a Guide Not a Rule

Jens Winkelmann is trying to figure out where he and his wife want to retire. They recently ordered a 4x4 camper van. They plan to retire in 2025 when Jens is fifty-eight and spend several years exploring Europe, North America, Central America, and South America in their van. Once they hit the road, they’ll be living off the proceeds of their retirement account. And with some luck, they might find the perfect place to settle down.

The 4 percent rule suggests that Jens and his wife should be able to withdraw an inflation-adjusted 4 percent from their portfolio’s value and not run out of money over a 30-year retirement. This “rule” was back-tested to 1926. That means, even if someone retired with a diversified portfolio of 60 percent stocks and 40 percent bonds in 1929 (before history’s biggest market crash) they could have withdrawn 4 percent of their portfolio’s value at the beginning of that year and made annual, inflation-adjusted withdrawals. After 30 years, they would have still had money left.  

Jens, however, has a few concerns about the 4 percent rule. Plenty of people say the safe withdrawal rate should be 3 percent or 3.5 percent. That might be true.  But the reasons for a new, sustainable withdrawal rate for people retiring next year or five years from now are flawed. After all, such asserters typically point to high market valuations and/or low bond interest rates.

However, nobody knows what market valuations will be next year, the year after that, or in 2025, when Jens and his wife retire. Market valuations might be lower than they are today, making arguments for the 4 percent rule even more robust.  Nobody knows, either, what inflation rates will be.  Nor does anyone know what newly issued bonds will yield.

However, instead of holding fast to a 3 percent, 3.5 percent, or 4 percent inflation-adjusted withdrawal rate, investors should treat such “rules” as flexible guidelines. 

Jens might prefer that. For example, he recently sent me a message to say, “If the stock market crashes a couple of years before I retire, my portfolio’s value could be lower than it is right now. Therefore, if I begin my inflation-adjusted 4 percent withdrawals in 2025, I might be withdrawing far less than I would have if I had retired today. That means, over my lifetime, I’ll be withdrawing far less money.”

Here’s what he means. Assume Jens had a portfolio comprising 60 percent in a global stock index and 40 percent in a global bond index in 2000. Let’s assume it was valued at $500,000. If Jens retired that year and withdrew 4 percent during the first year of his retirement, that would amount to $20,000.

Here’s a different scenario. Assume Jens decided not to retire in 2000. He planned to work three more years, until the beginning of 2003. Assume he continued to add $1000 a month to his investment portfolio over those next three years. Unfortunately, stocks fell hard in 2000, 2001, and 2002. So, despite adding more money every month from 2000-2003, his portfolio would have been worth $448,108 when he was ready to retire in 2003. That’s less than it would have been worth in 1999. What’s more, if Jens withdrew 4 percent of his portfolio in January 2003, that would amount to $17,924 of “income.” That’s $2,076 less than he could have withdrawn if he retired three years earlier!

But as I mentioned, the 4 percent rule should just be a guide. Here’s why:

Assume Jens retired in 2003. The markets would have kicked his portfolio to the curb over the previous three years, so it would be worth $448,108. He withdraws 4 percent during the first year of his retirement, amounting to $17,924. 

In 2004, Jens would have withdrawn $18,261. Inflation was 1.88 percent the previous year, so that represented a 1.88 percent raise over his initial withdrawal of $17,924. In 2005, he would have withdrawn $18,855…once again, giving himself another raise to cover the previous year’s 3.26 percent inflation rate.

But because Jens would have begun his inflation-adjusted withdrawals with the markets at a low, stocks would have had higher-than-usual potential for future growth. As such, despite his continued inflation-adjusted withdrawals, Jens’ portfolio would have swelled to $691,657 by the end of 2006, according to portfoliovisualizer.com. That year, he would be scheduled to withdraw $19,499.  But that would represent just 2.8 percent of Jens’ portfolio value.

This can happen when someone retires after a big market crash. Stocks eventually recover strongly when they’re priced at low levels. And when they recover, retirees might end up withdrawing far less than they could.

If this happened to Jens, he could have reassessed his plan in 2006. Instead of withdrawing $19,499 (as scheduled) he could have withdrawn 4 percent of his portfolio in 2006, and made inflation-adjusted withdrawals in the years that followed.  In that case, he would withdraw $27,666 from his portfolio that year, instead of the $19,499 that was previously scheduled.

The 4 percent rule was back-tested to 1926. But that doesn’t mean we couldn’t face tougher times in the future than we did in the past. Your retirement could face a nastier time than the financial crisis of 2008. Stocks could get hammered by a longer multiple-year decline than we saw in 2000, 2001, and 2002. Stocks might plunge down a deeper gorge than we saw during the market crash of 1973-1974. Heck, you might even face something worse than 1929.

Nobody (I repeat, nobody) can see the future. That’s why you should use the 4 percent rule as a guide. If back-tested research makes you nervous, go ahead and withdraw less than 4 percent during your first retirement year. Or, start out withdrawing an inflation-adjusted 4 percent, but during years when stocks fall, don’t give yourself a raise. Perhaps, you could even withdraw a little less during years when stocks fall. This will increase the odds that your money will last longer than 30 years. And if the markets soar, and your systematic withdrawals end up being far less than 4 percent of your portfolio’s value (such as the hypothetical example with Jens) give yourself a raise.

No, this might not be as simple as sticking to a hard and fast rule. But with a bit of flexibility, we boost our odds of not running out of money and not short-changing ourselves when the markets fly.

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