While I was going through my research about retirement withdrawing strategies, I’ve seen several articles discussing the 4% rule withdrawing strategy. In general, I’m against pretty much any rule of thumb used or suggested in the investing world as everybody’s situation is unique. This means, that we don’t have the same money, same lifestyle and same investing strategy. Therefore, how can a rule of thumb be applied? Investing is very personal and there is more than a single good answer to a question. Today, I’m going through the 4% rule to determine if it makes sense or not.
What is the 4% rule?
Invented in the mid-90’s using data between 1926 and 1976, the 4% rule is a retirement withdrawing strategy. The idea of this research was to find the magic number one investor can withdraw from his portfolio without being afraid of outliving his portfolio.
The idea is quite simple, but works well on paper. Assuming you have a well-balanced portfolio (a mix of stocks and bonds), chances are you will be making more than 4% on average. Over a long period (over 10 years), financial studies have proven that a balanced portfolio (about 50-60% in stocks and 40%-50% in bonds) will go through all market crashes and still post a 4% total return.
Therefore, if you withdraw 4% of your portfolio each year, you will most likely never see the end of your portfolio. Your portfolio is expected to generate anything between 4 and 5% in return. By withdrawing as much (or lower) than your investment return, the 4% rule ensure that you will enjoy your retirement without any worries. Looks well on paper, right? Let’s take a deeper look at this rule of thumb to see if you can still use it.
4% Rule main flaws
Before I tell you what I think of the application of the 4% rule in the real world, I’ll start by an outline of its flaws. It is easier to determine if a strategy fits your situation if you understand its downside.
This Rule of thumb doesn’t consider your asset allocation. As mentioned in my definition of the 4% rule, this strategy has been designed for a balanced portfolio. If you show 80% to 100% invested in certificate of deposits or in bonds, chances are your portfolio can’t post a 4%+ return over a long period of time. Therefore, the whole idea of withdrawing an amount in line with your return falls. If you generate 2-3% return and you withdraw 4% of your portfolio, you will hurt your capital.
The rule is old. Considering the study focused on years between 1926 and 1976, I’d be curious to see the conclusion of the same study based on 1977 to 2018. This would include a few years of very high interest rates followed by decades of ever decreasing rates. Can you still use the 4% rule if you have 50% of your portfolio invested in bonds paying 2-3%? This will hurt your overall returns.
The 4% rule doesn’t consider inflation. If today you need $50,000 to retire, the 4% rule suggests you multiply this number by 25 (or divide it by 0.04) to get your magic retirement number. In this case, $50,000 X 25 = $1,250,000. However, inflation is not considered in the calculation as on year #2, you will need $51,000 to keep up with an inflation of 2%. Therefore, on year#2, your portfolio must show a total value of $51,0000 X 25 = $1,275,000. This is an increase of another 25K on top of the 40K you just withdrew. Therefore, if your portfolio doesn’t generate a 6% total return, using the 4% rule will lead to reducing your capital year after year.
Where are the taxes in the 4%? That’s another problem. If you want to use the 4% rule, you must take the number before taxes, not after taxes. When you withdraw money from any accounts (unless you are Canadian and you have all your money invested in a TFSA), you are subject to pay taxes. Therefore, if you need $50K per year to live, you will need to withdraw more than 40K. If your tax rate is 20%, you will need to withdraw $62.5K. When withdrawing $62.5K, the first 20% will go to the Government (62.5K * 20% = 12.5K) and the rest ($50K) will go in your pocket. Therefore, you must multiply the 62.5K by 25 to get the “real” magic number of $1,562,500. This starts to get expensive, don’t you think?
Reading this section probably took away your smile on your face. You were probably happy to finally find an easy rule to follow to manage your retirement portfolio. Don’t cry just yet! Now that you think I’ve debunked the four percent rule, let me show you when you can use it.
Does the 4% rule work?
Now it’s time to rejoice; the 4% rule works for most investors. Most investors will generate a return matching (or exceeding) 4% as long as they are not fully invested in bonds. To achieve such results, you must have over 60% of your portfolio invested in the stock market. You can decide to invest in stocks directly, but ETFs and mutual funds will most likely work the same way. The key here is your asset allocation.
Also, if you match the 4% without inflation, this is not the end of the world either. Imagine your portfolio generates a 4% return and you withdraw a total of 6% each year. In the end, you are only withdrawing about 2% of your portfolio. In other words, your portfolio could easily last 30 to 40 years with such withdrawing rate.
If there was a portfolio generating what you need to keep-up with the 4% rule, would you take it? In the simplest world, you would find a portfolio generating a yield between 4 and 5% that provides steady dividend increase to keep-up with inflations. This way, all you would have to do is to withdraw your money yearly and enjoy retirement. Is this realistic? You bet it is!
How you can use the 4% rule
I was able to build a portfolio showing a 4.50-5% yield with a minimum of dividend growth to cover inflation (and more). Therefore, you could use this portfolio with a “4% withdrawing rules” and you should be good to never take money away from your capital. I’ve also avoided investing more than 20% in a specific sector. This ensures a strong diversification to go through any kind of crisis. You are curious? I’ve built a Canadian and a US retirement portfolio and they start on July 31st. DSR members will be able to build their portfolio at the same time and follow our trades. You can learn more about DSR retirement portfolio here.