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  • Nate Carter

Three Steps to Strengthen the 4% Rule

The 4% Rule Origin Story


Many savers are familiar with the 4% rule for drawing down savings in retirement. William Bengen launched the 4% rule revolution in 1994 with his article Determining Withdrawal Rates Using Historical Data. Bengen found that a retiree with a portfolio of 60% stocks and 40% bonds could sustainably withdraw 4% of their portfolio each year. Retirees will need to rebalance their portfolio once a year, many choose to use their birthday. Retirees are able to increase annual withdrawals to account for inflation.


Bergen's study showed no historical period where a 4% withdrawal rate exhausts a portfolio before 33 years, and in most cases a portfolio lasts 50 years or more. The simplicity of the rule helped it to become a new standard for withdrawing retirement funds.


4% Rule in Practice


In practical terms, applying the rule to a $1 million portfolio allows a retiree to withdraw $40,000 in their first year in retirement. If inflation is 3% they withdraw $41,200 in their second year of retirement. The stocks portion of the portfolio is invested in low cost index funds like the S&P 500. Similarly, the bond portion is held in bond index funds. The key to the 4% rule is consistency and not panic selling positions in down markets.


4% Rule Faces New Critics


More recently the 4% rule is coming under criticism. Frequently this is because critics misinterpret the original article. The 4% rule is a guide, not a set in stone guarantee. It is also based on past performance, and there is no crystal ball to predict future markets. The rule merely shows that based on historical returns, portfolios should last for 33 years, with a strong possibility of lasting 50 years.


Higher Stock Market Returns and Inflation Risk


Some financial advisers are now recommending the 4% rule be replaced with more conservative annual withdrawal rates between 3% to 3.7%. Including Morningstar which now recommends a 3.3% withdrawal rate. There are two main reasons why lower withdrawal rates are recommended.


First, financial planners want to prepare clients for lower market returns. The average historical return for the stock market is about 10.8% but advisors like Schwab say returns may be closer to 6.6% for the next decade. Erring on the side of caution can be wise, but it may also lead to retirees to taking smaller withdrawals than are necessary.


The second concern is rising inflation. The Federal Reserve tries to keep annual inflation at about 2%, but inflation is climbing. Inflation risk is devastating to retirees as it reduces the purchasing power of their savings. If inflation is 6% a product that costs $100 today will be $106 next year and $112.54 the year after. Higher inflation exhausts a portfolio more quickly. However, some temporary spikes in inflation were in Bengen's study, so unless inflation remains stubbornly high, the 4% rule is still a reasonable guide. But retirees need to be cautious if there is an extended period of high inflation, it will make lower withdrawal rates necessary.


Risk of Withdrawing Too Little in Retirement


Using an overly conservative withdrawal rate also has risks. A 3% withdrawal rate lowers the annual income from a $1 million portfolio from $40,000 to $30,000 for the first year of retirement. This means retirees live on tighter budgets when they are younger and more active. It can lead to retirees putting off necessities like medical treatment or serious home repairs. It may also lead to dying with far more assets than expected. Many of us did not achieve financial freedom only to let our heirs reap all the financial benefits.


Peace of Mind Justifies a Lower Withdrawal Rate

In fairness to the critics it makes sense to use a lower withdrawal rate if it helps a retiree sleep at night. A key component of a successful retirement is minimizing financial stress and maximizing long-term happiness. There may be periods in the future when a lower withdrawal rate would be prudent. Using a safe withdrawal rate calculator can help future retirees find an appropriate withdrawal rate based on their portfolio mix. If a retiree is more comfortable with a rate below 4%, they should use it, at least initially in retirement. The retiree can raise their withdrawal rate to 4% after some years, when they are comfortable with their investment returns and inflation levels.


Suspending Withdrawals in Recessions


Personally, when it comes to retirement, I like to stack the cards in my favor. The greatest risk with the 4% rule is taking withdrawals when assets prices have significantly declined. Particularly, in the first five years of retirement. For example, during the stock market sell off in early 2020 stock values fell by more than 25%. Continuing withdrawals during this period hurts the longevity of your portfolio. However, the selloff was brief, starting in February and recovering in April. By November stocks were gaining new highs.


Retirees who suspended or reduced withdrawals during these nine months protected to their portfolios. Fortunately, the worst of market downturns are often brief. The Motley Fool reports that the S&P 500 index has declined between 10% and 20% a total of 29 times since 1946 and it took an average of four months for the market to recover. Retirees who suspend withdrawals during these months will see their portfolios benefit for decades to come.


Three Steps to Strengthen the 4% Rule


Below is a three steps process to help retirees strengthen the 4% rule by periodically suspending withdrawals during market selloffs. This approach can also be used if a withdrawal rate is lower than 4%. When used properly it helps retirees maximize their investment returns. Over time retirees may even be able to increase their annual withdrawal rates, providing more income later in life. This of course depends on inflation levels and investment returns.


1. Emergency Funds: First, set up an emergency fund invested in cash or cash equivalents to cover a few months of living expenses. This cash protects you from needing to sell assets. This emergency fund can be supplemented with access to a home equity line of credit (HELOC) to access cash without selling assets. It is far better to pay $600 in interest on $10,000 from a HELOC than to sell $10,000 in stock that has fallen in value to $7,500. Selling the stock would lock in a loss of $2,500. When asset values recover, rebuild the emergency fund and pay off any HELOC debt.


2. Asset and Income Diversification: The second step is to diversify your retirement portfolio beyond just stocks and bonds. Owning one or two rental properties, a modest annuity or part of a small business provides more diverse income streams. This additional income makes it easy for retirees to suspend their retirement withdrawals. Especially if markets see a lengthy downturn like the 2007-2009 global financial crisis, which could necessitate suspending withdrawals for a longer period. In addition, adding in some part-time work or a side hustle may help eliminate the need for withdrawals. Some of this income can also be invested in stocks that have fallen in value. The best time to buys stocks are when they are on sale.


3. Delaying Expenses: The third step is to delay major expenses during the market downturn. Buying new appliances, taking major vacations or replacing vehicles can be put off for a year or two if necessary. This gives your portfolio time to recover in value. Remember these sacrifices are only temporary, just to weather the worst of market declines.


If you are interested in learning more on these topics see the links on creating passive income, withdrawing funds in retirement, and investing in real estate.


For a deeper dive into creating a plan for financial freedom see the book Become Loaded for Life and the 10 Stages Workbook.


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