Retirement Income Part 2: The 4% Rule + Why the Creator Doesn't Follow It
17:54 Share

Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm continuing with our retirement income series by diving deeper into the 4% rule, its history, and the pros and cons of using it to turn your investment portfolio into a retirement paycheck.

To grab the links and resources mentioned today, just head over to youstaywealthy.com/122. So one of my all-time favorite quotes about investing is from David Booth, where he says, "The most important thing about an investment philosophy is that you have one that you can stick with." And I haven't checked with him personally on this, but I think he's really sincere about it, even if he doesn't agree with the approach that someone is taking.

In other words, if you believe in active stock picking, then own it, master it and stick with it for the long term. You can be successful. If you prefer low cost passive index funds, then commit to it for the long term and you will have success. But if you're jumping from stock picking to mutual funds, to passive ETFs, to hedge funds or annuities, and then back to picking stocks again, you're just setting yourself up for failure.

Not only are you likely triggering taxes and transaction fees along the way by jumping in and out of investments, but chasing trends and fads have proven time and time again to lower your investment returns.

Even worse, choosing an investment strategy that doesn't match up with your tolerance for risk can lead to you buying and selling at all the wrong times which can absolutely destroy someone's retirement plan and in some cases be almost impossible to recover from. The same can be said about retirement income withdrawal strategies.

Choosing one that best fits you and your retirement needs and sticking with it over the long term is going to put you in the best position for retirement success. But that's not typically what I see when I talk to people and I review financial plans and meet with new clients. As humans, we constantly feel like we need to be tweaking, changing, and pivoting. We're hardwired to think that action equals good and inaction equals bad.

One year it's the 4% rule and then the next year it's dividend stocks and then we get sucked into buying an annuity and then we decide to take a crack at rental real estate. We often find ourselves chasing what appears to be the next best thing only to find ourselves questioning if what we're doing is truly the best thing that's out there or wondering if maybe there's something better.

In many cases in life, maybe in most cases, doing more and taking action truly is the right strategy. If you're in a relationship and your relationship is struggling, well, it probably makes sense to take action and get help and maybe get some therapy. If someone breaks into your home in the middle of the night, it probably makes sense to take action and call the police and find safety.

But when it comes to investing and choosing retirement income strategies, I think John Bogle put it best by saying, quote, don't do something, just stand there. So as you listen to today's episode and this entire series, I want to urge you to keep all of this in mind.

While I will be pointing out some major flaws in some of the most popular retirement income strategies, including today's topic around the 4% rule, it doesn't necessarily mean that you shouldn't use these strategies or stick with them if you're already committed to one. The grass isn't necessarily always greener, and the most important thing is that you find a strategy that works best for you and stick with it.

The caveat, of course, is that if you're truly relying on an approach that's either one, putting your retirement in jeopardy, or two, is just objectively a bad strategy that perhaps you just didn't know enough about when you adopted it. For example, using high cost variable annuities or non-traded REITs to create income in retirement. If that's the case, then you might find a new strategy to commit to for the long term.

So my goal today and always on this podcast is to give you all the information you need to make an educated and informed decision, not to scare you into making a change or prove that what you're doing is wrong and what I'm doing is right.

So with that, let's dive in today to the 4% rule, its history, some of the pros and cons, and then some really important things to take into consideration if it's something that you're currently using or plan to use in retirement. In short, the 4% rule aims to provide steady income while greatly mitigating the chances of your retirement savings going to zero, right? That's everybody's fear, you know, depleting their retirement account.

The original version of the rule assumes that you have a portfolio allocation of 50% stocks, 50% bonds. However, some now suggest that that should look more like 60% stocks and 40% bonds, which does seem more appropriate. So we're going to roll with that for today.

So the original version of the rule assumes that you have, let's call it 60% stocks, 40% bonds for today's sake. It also assumes that you're retiring at age 65 and you have a 30-year retirement time horizon. And putting all this together, the rule ultimately says that you should use no more than 4% of the value of your portfolio in the first year after you stop working.

Let's put some numbers to this. So for example, if you retire with a million dollars in your 60% stock, 40% bond portfolio, the 4% rule would say that you can withdraw $40,000 per year for the next 30 years.

The amount would only increase with inflation. So if in year two of retirement, inflation is let's say 3%, you can withdraw $41,200. That's 3% times 40,000 equals $1,200. So you would tack on that $1,200 to the original $40,000 number.

The 4% rule, as you might know, is based on a very famous 1994 research paper written by William Bangan. William obviously often goes by Bill. I'll link to Bill's original academic paper in the show notes if you've never read it and you want to check it out.

Bill is obviously wildly known for coining the 4% rule in this paper that he wrote. However, he actually doesn't adhere to the rule as strictly as you might think. He's on record saying that it has always been treated too simply and that historically it was based on, quote, the worst case scenario. It was based on someone who retired at the worst moment he could find in modern times, which at that point was October of 1968.

As Michael Kitsis noted last week, the 4% rule is more likely to quintuple wealth than to deplete it. The real safe withdrawal rate for someone retiring in October of 1968, that worst case period that he looked at, was actually closer to 4.5%, which Bill has since acknowledged.

And personally, Bill says that he uses a withdrawal rate of 5% for his retirement portfolio. And he's quoted saying that the rule is based only on the data we have going back to the 1920s. He says one size doesn't fit all and the number you choose could be anything.

It's not necessarily the most comforting thing that you want to hear from the man behind all this research and praise around the 4% rule and his academic work. But to me, I actually kind of find it refreshingly honest. His intent was never to suggest that this is the answer and that everyone should adopt it exactly how it was written in the textbook.

As an academic, he did the research and he worked with the data he had and he published his paper knowing that there are other solutions out there and also knowing that the future could certainly look different than the past. Now, just because the rule is based on outdated historical data and Bill has made some updates to the original paper since it was first published doesn't necessarily mean that the 4% rule is bad or that it should be avoided. In fact,

Quite the opposite. I'd say it's a great strategy to consider. And so with that, here are some of the pros of the 4% rule to take into consideration. The first is it's simple and simple beats complex almost every time, which is one of the reasons why most of us are fans of low cost passive indexing. Number two, it's predictable.

Unlike some of the dynamic withdrawal strategies, which we're going to be getting into in the coming weeks, the 4% rule creates a nice, steady paycheck that doesn't fluctuate. This makes planning and budgeting in retirement much easier, especially for those that might not have the best habits around money and spending. And if you're one of those people that's more worried about outliving your savings than dying, it puts you on a nice, predictable income retirement paycheck.

The third pro that I've identified is that it's a relatively conservative approach, given that it's based on the worst case scenario. And like Kitsis shared last week, the odds of quintupling your wealth are better than depleting it. It's one of the more conservative withdrawal strategies out there. Historically, it's done a great job protecting retirement savers from running out of money, which, as I shared last week, is the number one concern for most people.

Now, before you start emailing me, I will acknowledge, will the 4% rule do that for the next 30 years? And I don't know. I don't have a crystal ball. That's a longer conversation for us to have. But given the historical data that we do have, we can agree that it has proven to be historically a more conservative approach.

Now, let's look at some of the major cons of the 4% rule. The first is it's based on past performance and the original paper was published almost 30 years ago.

To give that some context, 30 years ago, interest rates were around 5% versus close to 0% today, meaning that bonds have been able to contribute a lot more to a portfolio, you know, over the last 30 years, especially as interest rates continued to fall during that time period. So not only are you receiving, you know, 5%, 6% interest on those bonds, but

as interest rates have come down, the value of those bonds have also propped up the portfolio even more. So bonds have contributed a lot. So if you're retiring today, when stock market valuations continue to creep higher and higher and bonds are practically paying nothing, a plain vanilla 60% stock, 40% bond portfolio just might not cut it if you're attempting to follow the 4% rule.

You might need to increase your stock allocation or improve the construction of your portfolio, which we'll talk about shortly. Or you might have to reduce your withdrawal rate. This 4% rule might turn into the 3% rule, which leads to the second con. And that is that the 4% rule might force risk averse investors to take on more risk than they're comfortable with. Let's just push aside the current market conditions for a minute.

Even a 60% stock, 40% bond portfolio can make a lot of people uncomfortable. For example, from the top of the market in November of '07 to the bottom in March of '09, a 60/40 portfolio lost almost 30% of its value and it took almost two years to recover and get back to even again.

That's a lot to stomach for a retiree who's relying on their hard-earned money to safely get them through retirement without losing sleep at night. One small mistake, one irrational sale of investments during a difficult time like that, and you can pretty much throw the original retirement plan in the trash.

Now, looking at today's environment, a retirement saver looking to use the 4% rule might have to allocate even more to stocks, something like 70% stocks or 80% stocks, exposing them to even more risk that might make them even more uncomfortable.

The third con to take into consideration as we begin to get nerdier and nerdier with this retirement income series is that a 4% withdrawal rate simply might not be high enough. For some retirement savers, the goal is to maximize the income from their portfolio and to die with as little money as possible without, of course, putting their retirement in jeopardy.

In that case, the 4% rule just might not cut it for them. And while there's no magic bullet out there and you will certainly be accepting more risk as you hunt for more return and higher withdrawal rates, there are other academically sound income strategies to consider that would likely better match up with someone's goal of maximizing income from their portfolio above that 4% number.

We'll be getting into some of those in the coming weeks here, but for now, let's just know that if 4% doesn't sound like a high enough number, you're likely not alone. It's one of the cons of this rule, and there are other solutions to consider. Like Bill Bangan said himself, this isn't a one-size-fits-all strategy.

The last con that I want to share is for those that have early retirement goals. Remember that Bangin's original paper was based on a 30-year retirement. So if you plan to retire at 60 or even 65, well, 30 years seems like a relatively appropriate time horizon. But if you retire at age 40 or 45 or you have plans to retire around that age,

you might be looking at a 50 plus year retirement time horizon. And according to Vanguard, that brings your chance of success down to 36% using the 4% rule.

So once again, you might need to reduce your withdrawal rate or possibly take more risk with your investments or retire later or find other income streams. Or you could always roll the dice and just know that you may be going back to work one day if markets don't cooperate in your favor. I don't necessarily recommend that, but that flexibility is maybe something to consider if you do have early retirement goals.

Now, just for now, just know that your retirement time horizon is a very important piece of this equation. And for all you early retirees out there, you have some more math to do before implementing this rule.

One last thing I want to mention today for you to think about and digest as you wait for next week's episode is that the 4% rule was originally based on U.S. stocks only. I've talked at length on this podcast about the importance of diversification and the benefits of diversifying overseas and the problems with having too strong of a home bias and only investing in the U.S. stock market.

Remember that while the broad U.S. stock market might seem overvalued, there are segments of the international markets that are undervalued or more fairly valued, and investing in those might help to boost future returns of a globally diversified portfolio. In fact, Vanguard is on the record saying that adding international stock

to an early retirees portfolio that has a 50 year time horizon increases their chance of success from that 36% number I just shared up to over 50%, specifically 56%. And Vanguard's research was based on adding 40% of their equity allocation to international stocks and keeping 60% of it invested in US stocks.

Also, one more thing to note, remember too that there are pockets of the US stock market that do have more appealing valuations than just the plain vanilla S&P 500 that the talking heads in the media talk about every single day. Small cap stocks, mid caps, large caps, value, growth, momentum, profitability. There are a lot of ways that you can slice and dice the stock market and maybe invest more prudently to set yourself up for a higher expected future return.

As we will get into in more detail in an upcoming episode here, your asset allocation becomes really, really important when you turn your investment portfolio into a retirement paycheck, especially when relying on a systematic withdrawal strategy like the 4% rule or some of the others that we're going to be talking about. So in the end, and as mentioned towards the beginning of this segment, the 4% rule is far from perfect. Well,

While it can certainly be used for your retirement withdrawal strategy if implemented correctly over a long period of time, for some of you, it can simply just be a good starting point for the retirement income conversation. Multiply your projected savings on your retirement date by 4%.

add in some other income sources that you might have like social security, maybe a pension, and you can begin to get a rough idea of where you stand and if you're on track for retirement or if you've saved enough money for retirement. Next week, I'm going to be diving into two more popular retirement income strategies and their pros and cons. One of them is dividend investing and the other is using insurance products like a variable annuity or even a single premium annuity.

So stay tuned for all the links and resources mentioned from today's episode. Again, head over to youstaywealthy.com forward slash 122. Thank you as always for listening, and I will see you back here next week.