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We have all heard of the 4% rule. We know the S&P index has return an average annual return of 10.26% since 1957. Even considering inflation and sequence of returns, how is it possible to run out of retirement funds sticking to the 4% strategy and using cash during downturns. In fact, isn’t more likely assets will grow?
Oops, just noticed this is an old post.
I only see the 4% rule as a useful tool for estimating a ballpark figure as you near retirement. It provides a simple formula: your needed portfolio balance is 25 times your desired annual spending, which in theory gives you a low probability of depleting your funds over a 30-year period.
As for your actual question, you’re right that over the long term, I fully expect to see my retirement accounts grow. But I also wouldn’t be surprised if at some stage the value halved due to severe market volatility. That’s the reason for a conservative withdrawal like 4%—it’s a tool to smooth out the long-term volatile nature of the markets. The biggest risk is not a low average return, but the sequence of returns risk that you mentioned.
Personally, I wouldn’t implement such a rigid strategy. A more comfortable and realistic approach for me involves a mix of fixed income and a dynamic withdrawal strategy. I also keep ten years’ worth of cash outside my retirement accounts as a hedge against that early years’ sequence of returns risk, an opportunity cost I’m indifferent to.
A key flaw of the 4% rule is that it doesn’t even account for the impact of taxes on the withdrawals.
It’s purpose is to help people make sure they don’t run out of money under a worse case scenario, so if you don’t experience a worse case, assets will be higher than otherwise. It isn’t supposed to ensure your assets don’t grow. It’s a conservative approach to withdrawing assets in retirement that will likely result in a large estate at death.
In answer to your exact question: yes, it’s more likely your assets will grow (but you cannot be 100% sure).
I think a better question might be: since the 4% rule was invented 30 years ago, if a person followed it, how would it have worked out.
I’ve searched the internet without finding an answer.
Sorry, I copied the wrong 2nd link. It should be this one.
https://www.bigpicapp.co/bigpicapp/index?v=free
Michael Kitces wrote about newer software that assess safe withdrawal rates.
https://www.kitces.com/blog/safe-withdrawal-rate-calculator-software-big-picture-timeline-app-reviews/
He references the BigPictureAp which calculates historical safe withdrawal rates. I checked this morning and for someone who retired on Jan 1, 1994, the safe withdrawal rate would have been 6.5%.
https://www.kitces.com/blog/safe-withdrawal-rate-calculator-software-big-picture-timeline-app-reviews/
The 4% rule was based on a 60/40 stock/bond portfolio and looked at historical returns. The idea was to find a “safe withdrawal rate” that worked in almost all scenarios for a typical retirement period. In fact, the safe withdrawal rate in many scenarios was significantly higher than 4%. 4% was supposed to be a rule of thumb for safety. Here’s a great explanation to help clear up the confusion. It has a great, simple table that depicts returns since 1907
https://www.kitces.com/blog/what-returns-are-safe-withdrawal-rates-really-based-upon/
So, will a person following all that run out of money if they can use cash to smooth significant market drops?
Bill Bernstein’s second edition of The Four Pillars of Investing makes a convincing case that the returns we’ve seen over the past ~50 years, from large caps like the S&P 500 stocks, will be lower going forward because the steady rise in valuations (higher Price/Earnings ratios) we’ve enjoyed will not continue. If he’s right, and if that concern isn’t simply addressed by an overdue deep bear market, then a lower draw rate of about 3% would give you a higher margin of safety over 30+ years of unpredictable market returns.
Even with the great returns of the past decades, when Bill back-tested 4% draw rates, the worst-case scenario was for someone who retired in 1966. That person’s portfolio drew down to zero in a bit over 20 years.
And I believe the 60/40 portfolio was elected to help smooth out market swings. Since the study used actual historical returns, it shows how things would have behaved in real situations. It doesn’t not guarantee future returns. People have studied a wide varieties of forms of the 4% rule, and you seem to be able to do better, albeit with more complication. I’m not sure anyone has tried to model using the 4% rule with a pile of cash, and foregoing withdrawals after bad years and using available cash. I suspect it would result in a reduced standard of living.
It’s the sequence of return risk that results in the potential to eventually run out of money. It’s just less likely using 4%. Mr. Quinn, what I think is presumed in the 4% rule is that one does NOT have extra cash outside of the nest egg. The 4% rule is presuming that all money is invested.
Not sure that is the case if you define nest egg as retirement funds. If you have $500,000 in an IRA and $500,000 in a brokerage account, do you apply the 4% to the IRA or both?
I don’t know the answer myself. I would tend to say the IRA, but I’m not sure that is the intent.
In the Appendix of his original artcile, Bengen assumed a 50/50 stock-treasury bond portfolio and stated that the effect of taxes is neglected, as if all retirement money were stored in a tax-derred account. Analysis for a taxable account would be considerably more complex.
https://web.archive.org/web/20120417135441/http://www.retailinvestor.org/pdf/Bengen1.pdf
Thus, while Bengen’s assumption obviously doesn’t mean that you can’t withdraw taxable assets to support your retirement it does mean that estimating the optimal withdrawal rate is more complex than it is if you are only withdrawing tax-deferred money.
Right. Any cash should be from the 4% plus inflation withdrawal.
Few thoughts. I don’t know anyone fully invested in the S&P, so their actual results vary. And even though they claim to adhere to 4% they actually dip into the cookie jar when their wants overpower their needs.
I suspect you are right and that’s the key to failure. Seems to me you need two cookie jars to make it all work, one for dipping
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