The 4% rule states that you should continue to build your retirement nest egg until you have a balance large enough to support withdrawing 4% of initial balance each year.
What is the 4% Rule?
A simple example is that if your liquid net worth at time of retirement was $1 Million, you would plan to withdraw $40k each year.
This model was developed to bring simplicity to the question of when do I have enough to retire?
People are comfortable understanding what their current income levels are, and answering the question of whether they could have an enjoyable life at the 4% distribution rate.
However, this simplified framework doesn’t work. The stakes are too high to not fully understand all assumptions at play. The faulty assumptions that underpin this framework are listed below:
- Asset Allocation Plays a Large Role
- Alternative Investments are Key
- Distribution and Dividend Income are Under Considered
- Large Expenses Early
- Inflation: You have to Be Precise
- Fees and Taxes
The 4% rule has its origins from a 1998 publications called Retirement Savings: Choosing a Withdrawal Rate that is Sustainable. It was published by 3 professors from Trinity University; therefore, the study is often referred to as the ‘Trinity Study.’
The base underlying assumptions of this study is that if a person were to carry a 50/50 split between equities (S&P 500) and Fixed Income (Long Duration Bonds), then they will have a greater than 95% chance of their portfolio lasting longer than 30 years.
There have been subsequent surveys and reviews that have documented how prevalent this “rule” is in the Retirement Planning world.
In 2008, a Stanford University study, co-authored by Nobel Laureate William F. Sharpe, stated they were “struck by the universal popularity of the 4% rule–retail brokerage firms, mutual fund companies, retirement groups, investor groups, financial website, and the popular press all recommend it.”
This study went further by saying the 4% rule “is the most endorsed, publicized, and parroted piece of advice that a retiree is likely to hear.”
And that is what prompted me to write this piece. Just because something is said often, and by professionals, doesn’t necessarily make it right (for you).
Let’s work through the assumptions so you are making an informed decision.
Slaying the Assumptions of the 4% Rule
The below charts and tables consolidated and published by the Jackson National Life Insurance Company ® does a very good of framing assumptions.
From left to right the simplified points being made are (1) to get 4% spendable cash out you’ll need to withdraw much more than that. (2) In fact, the middle chart shows you need to bump that rate up by 40-45% to get the net 4% in cash–5.3 to 5.8% withdraw rate. (3) Finally, the table to the far right shows after doing several Monte Carlo simulations, how you carry assets is a primary driver of sustainability.
If we return to the original model assumption of a 50/50 balance between stocks/bonds, you will see that the likelihood for success (making it 30 years) drops to 84%.
Asset Allocation Plays a Large Role
As you can see in the above modelling, the higher the allocation to stocks the higher the success probability at the high-end of withdrawal rates.
So if you intend to take distributions north of 5%, you will need to shift to stocks.
The other interesting point in the modelling is to optimize success rate, it really is a combination of lower withdraw and conservative asset mix.
The highest probability of success is a 3% withdrawal rate and 25/75 stock/bond allocation.
This will get you in the 99% level of success probability.
The important characteristic of Monte Carlo is that it is taking the data across actual historic performance periods, and also randomizing data sequences. You are really trying to simulate low probability, extreme conditions.
The specific assumption that I am concerned with is if the Macro-Economic environment were to shift.
We’ve been living in a low-inflation world for the last 40 years. That means that fixed income has been in a sustained bull market. At the same time we’ve seen strong appreciation of risk assets. It’s truly been a best case world that we’ve experienced since 1984.
If we were to turn into a high inflation environment, Fixed Income would take a significant hit.
The assets that you would want to add to your portfolio to protect against an increase in inflation is Gold, Silver, Treasury Inflation Protected bonds (TIPs).
These additional assets should be added, and there should be special attention paid to the maturity ladder in the fixed income portfolio–near, intermediate, and long term bonds should have proper balance.
This concept of Alternative Investments are Key is the second assumption missing from 4% model.
The 4% modelling does not account for this paradigm shift. It should!
Distribution and Dividend Income are Under Considered
As carefully discussed in my overview of best funds for retirement, dividends and distribution play a significant role in preparing for retirement.
If you can establish a steady cash flow coming from your investment assets, it can take a lot of pressure off of modelling assumptions.
The historic 1.76% is about a quarter of what I would target.
The 4 percent distribution model considers the dividend yield of the S&P 500 but that is a sub-optimal asset selection for a proper retirement account.
I traditionally would shoot for around 7% dividend yield in my retirement portfolio. I do this for a few reasons.
One, this is the tax protected structure where it is most appropriate to hold high yield assets. Second, I like the compounding effects from having monthly (preferred) or quarterly dividends continuing to reinvest in assets.
When you have money consistently reinvesting it also gives you mental relief. When the market drops, you are buying more assets at a lower price.
It’s a self healing portfolio. When you keep investing, you own more shares, your distribution is therefore higher, and that cycle continues to repeat.
Large Expenses Early
Even at a 50/50 split between and bond and stock funds, the drawdown in the modelled portfolio can be substantial. In 2008, the S&P 500 dropped 38%.
There was an offset with bonds increasing in value, but total portfolio with this composition would have been down 24%.
A portfolio that has lost a quarter of its value, will have to return more than 33% just to get back to even. When you are pulling out distributions at these lower levels, the fight to get back to breakeven is even more difficult.
Let’s say the market rebounds over the next 5 years returning 10% per year (which is 30% higher than historic average over the last 30 years). Over that same period you have pulled out your 4% withdrawal x 5 (20% of original portfolio size). That would leave your portfolio down over 35% even with a sharp rebound.
Early large losses challenge this model, and will certainly stress even the most stable of investors.
Inflation: You have to Be Precise
As alluded to earlier, this model is too dependent on historic investment patterns not possible future ones.
The 50/50 allocation relies entirely on the inverse investment return relationship between stock and bonds.
In reality the underlying investment principle that drives the correlation between these assets is not precise.
It is possible that these two assets could start to move together. Let me provide a scenario.
The Federal Reserve has been reducing interest rates since the financial crisis in 2008. The rates have been bumped a 1/4 % higher a few times and we’ve been in a decade long recovery. If the world and specifically the United States head into a recession, the Federal Reserve would have very little room to reduce rates.
During this recovery the US government had continued to borrow funds and print money at a historically high rate which could trigger inflation.
In this scenario both stocks and bonds would face headwinds and the inverse relationship would weakened. This could be further accentuated if the bond portfolio held had a long duration (10 or 20 year Treasuries) bias.
Again, this establishes the need for a more eclectic portfolio than just two asset classes.
Fees and Taxes
Both fees and taxes have to be considered.
Retirees when considering the 4% withdrawal pace are equating that to their take home (after tax) paychecks. As illustrated in the Jackson analysis, in order to take home 4% requires you pull out up to 5.8%.
This higher distribution reduces the probability lasting 30 years by over 35%.
This study considered holding the S&P 500 and did not consider a fund for the fixed income portion.
The S&P 500 can be bought for very low fees.
Vanguard is currently charging less than .05% and Fidelity offers a free index fund for clients with a broader relationship.
The two problems with the above assumptions is that most people do not hold just the S&P 500 as the equity portion of their portfolio.
In fact, less than 3% of all investors with an equity stake greater than $50k hold JUST the S&P 500.
This will bring us back into management and marketing fees that average in the .75% to 1.25% range annually.
This is a quarter of the 4% distribution that was NOT accounted for.
Going to the fixed income side, the same issue persists.
The fixed income funds, based on complexity, can average from .5% – .8%.
Depending on your personal tax situation, you could be facing an incremental 24% – 33% end of year tax liability. At time of retirement, the average retiree will have over 85% of their total retirement portfolio in an account that is subject to income tax at time of withdrawal.
The 4% rule was created to bring simplicity to the ‘how much is enough’ question. However, that simplicity has come at the cost of precision.
Making the decision to walk away from a steady paycheck is a large life decision, so ensuring you understand all aspects of this model is critical.
Recognizing the importance of allocating funds to stocks, minimizing management fees, accounting for the tax hit at withdrawal, and increasing your allocation to inflation prone assets is the key to limiting the surprises that this model understates.
Let’s make sure this is a fully informed decision!
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