Retirement and the 4% Rule

For decades I’ve been reading about the 4% Rule and what it has to do with retirement.

The 4% Rule says that when you stop working for money and start creating an income from your savings, it’s the upper limit of what you should withdraw every year from your savings and investments to make sure you never run out of money.

The idea is to add up your savings and investments, and start withdrawing no more than 4% annually. In it’s purest form, it should be OK to increase the dollar amount you take by the current rate of inflation. That sounds simple enough and if your retirement is just around the corner, it’s as good a place to start as anywhere.

Running out of money during retirement is not a pleasant thought. The idea behind the 4% Rule is to impose an element of caution, one that can be expected to work under normal circumstances.

However, there is another risk we’re all exposed to. It’s called the ‘sequence of returns risk’. This risk is something over which we have virtually no control. It’s dependent on when we were born and by extension, when we decide we’ve had enough work years and decide to call it quits and retire.

The chart just below compares Client A with Client B. Client A retires in 1991 with $100,000 in retirement savings. Client B retires ten years later in 2001 with $100,000 in retirement savings. Forget for the moment the relative purchasing power of that money. Just look at the raw numbers.

Both of them start taking withdrawals at an annual rate of 4% from their respective totals. Both are invested 100% in the S&P 500. What’s different is the performance of the S&P 500 for their respective first ten years.

Look closely at the respective totals ten years later. Despite taking out 4% of an increasing amount, Client A’s money still grows to $332,300. Compare that number with the one faced by Client B and his money. Same investments, same 4%, but Client B’s money has shrunk to $76,482. Client A could have taken far more than 4% as annual income and still come out ahead of Client B, who is in a deep hole by the end of 2010.

My point is that ‘under normal circumstances’, the 4% rule might be OK, but without a crystal ball, you could find yourself in very deep manure. Making it a 3% Rule might help a little, but an adverse sequence of returns risk could still sink you.

Most people talking about the 4% Rule use an asset allocation mix of 50% stocks and 50% bonds, a 30 years time horizon, and an assumption the market will perform OK. It essentially says you won’t ever run out of money. For how many years will you and your spouse be alive? Are you willing to bet that your ability to pay your bills will never go away? I’m not.

So yes, it’s a reasonable starting metric, but far from convincing. How long do you plan to live? How will you invest your portfolio? Are you willing to make changes to your lifestyle if conditions change? Is inflation under control or could it spike before you die?

I may have you persuaded that it’s not really a rule. It’s a guess at best,  and like it or not, I’ve discovered that HOPE and GOOD LUCK are a recipe for failure when it comes to investing money for the future.

The only potential solution I have is for you to build a strategic road map for yourself and fully understand how you want your life to play out. And to get started creating your road map well in advance. There is a partial solution to this investment problem but it involves transferring some of the downside risk to an insurance company. That idea will be explored in another post soon.

Tony Kendzior, CLU, ChFC \ October 2, 2019

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