Creating an income stream from your nest egg presents some challenges. If you take too much, you increase the risk of running out of money. If you take too little, you can miss out on some of life’s experiences. Today we dig into the 4 percent rule. We explain what it is, and why we still believe in it.
Video: The 4 Percent Rule
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The Worst Outcome: Running Out of Money During Retirement
One of the things we talked about in a previous episode, was how your initial withdrawal rate impacts how long your savings will last. Unfortunately, we have seen people run out of money in their retirement. The primary reason they did–they withdrew too much money.
You see, if you don’t take money out of your nest egg, there is a very small chance of seeing your account values go to zero. But when you start taking income, you introduce that risk.
The “safe withdrawal rate” has been a hot topic in the financial planning world for decades. It continues to be the subject of many debates. The “holy grail” we are looking for is how much income you can take, and not run out of money.
The Basics of the 4 Percent Rule
What we have recommended the past 20 years is the “4 Percent Rule”. It’s pretty simple to compute, really. You take what you have accumulated over time, multiply it by 4%. And, then divide that by 12. That’s the monthly gross income you take from your savings.
Why Do We Use the 4 Percent Rule?
Two reasons: There’s a lot of research on this subject, and our own real life experiences.
We live in a world where investment returns are sometimes negative and always unpredictable.
You see, if those negative returns happen early in your retirement, things can get dicey. And if we have back to back negative years early in retirement…..Yikes that’s a whole different thing.
This is what people call the sequence of returns risk. If you retired at the end of 1994, and had 5 straight years of 20% gains in stocks…things looked really good. But, if you retired at the end of 1999, the picture was much different.
You pick a year to retire, and you have no idea if the next 12 to 24 months are going to be good or bad. And unfortunately that has a huge impact on your chances for success.
Let’s look at some real life historical situations. There are two major factors here: withdrawal rate, the annual percentage you take from your savings. And the allocation, the mix between stocks and bonds.
We’ll look at the three WORST bear markets in my lifetime, and I was born in 1971, so that’s where we start.
(Note, all allocations are 50% Stock 50% Bond, rebalanced annually. Stock Market returns are represented by the S&P 500 Total Return and bond returns are the annual total returns of 10-year Government Bonds. Rates of return illustrated are not guaranteed, and past performance does not predict future results)
1973-74 Bear Market
Top to bottom the stock market dropped just under 50%. There were two straight negative years. The 4% withdrawal rate is the dark green line. The year end values grew significantly over the next 20 years.
With the 5% withdrawal rate, things still worked well, but growth was more subdued. And at 6%, which is the light grey line, the portfolio was the initial amount two decades later. Not a failure, but probably not ideal either.
The Dot Com Bust: 2000-2003
It featured three straight years of negative returns. Total drop of roughly 50% in the stock market. The years that followed also included the great financial crisis. This 19 year period is the worst since the great depression.
The 4% withdrawal rate survived. The account value was below the initial investment. but it didn’t go to zero either.
The 5% withdrawal rate isn’t a complete failure and the 6% withdrawal rate goes to zero….Not good.
Great Financial Crisis: 2008-2009
And if you retired at the end of 2007—57% top to bottom decline in the great financial crisis…
The 4% withdrawal rate, has worked out, as has the 5% withdrawal rate. But 6% is worth less than the initial investment just over a decade later.
More Supporting Data
JP Morgan has provided some additional research which shows the probabilities of success of various withdrawal rates and various allocations.
Their research shows, somewhat conservative portfolios create better chances of success. But it is worth pointing out, being too conservative in some situations can also increase your longer term risk. Something to keep in mind.
One Last Thing: There are No Guarantees
Starting at a 4% withdrawal rate does not guarantee success. You’ll notice none of these scenarios show a 100% probability of success. Things can happen which could be far worse than anything we’ve seen before.