Rules of Thumb: The 4% Rule

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Most everyone is familiar with at least one rule of thumb, a “common sense” saying that comes pretty close to the truth, or, as defined by Tom Parker’s Rules of Thumb: Brilliant Guestimates, Shortcuts and a few Shots in the Dark, a “homespun recipe for making a guess.”

Retirement planning has its own rule of thumb, namely the 4% Rule. Popularized in the 1990s, the 4% Rule says that retirees can probably withdraw 4% of their investment portfolios in their initial year of retirement, adjust that withdrawal amount for inflation in future years, and not run a significant risk of outliving their dollars. The work that went into formulating the rule assumed that the retiree held a portfolio of 60% stocks and 40% bonds, and that the portfolio was rebalanced back to the original target each year.

But a March 1st article in the Wall Street Journal recently called into question the validity of the 4% rule. (Say Goodbye to the 4% Rule).  The article references work by T. Rowe Price that stated that if someone retired on January 1, 2000 and tried to use the 4% rule, their portfolio would have fallen by a third through 2010. They also estimated that such a retiree would only have a 29% chance of not outliving their assets over the next three decades.

Yikes! Maybe we should throw out the 4% rule (even though the back-testing that led to the rule analyzed all 30-year periods going back to 1926, which included the Great Depression!).

Or…maybe we should dig a little deeper. The T. Rowe Price study assumed a portfolio of 55% US Stocks and 45% Intermediate Bonds, a little more conservative than the original research. The T. Rowe Price folks also assumed portfolio rebalancing every month, and that annual withdrawals increased each year by 3% for inflation.

Monthly rebalancing seems a little frequent. Our current rebalancing schedule is twice a year; some planners only rebalance once a year and some do it even less frequently. Additionally, inflation (as measured by the Consumer Price Index) over the time period wasn’t 3%. It was actually 2.5%. And that’s an annualized figure: annual inflation ranged from 0.3% to 4.28% when you look at each individual year.

When you change the rebalancing period to once a year and use the actual inflation numbers for each year, the results look a little bit different. The portfolio still drops by 2010, but by 20%, not 33%.[1] And if you extend the time period out until January, 2013, the original portfolio had only dropped by 10% from its original value, all the while allowing the account owner to make inflation-adjusted withdrawals.

And that doesn’t even take into account the fact that the portfolio in the T. Rowe Price study was made up of just two assets: large US stocks and intermediate bonds.

With a more diversified portfolio including US Small Cap Stocks, Large and Small US Value Stocks, and International and Emerging Markets stocks[2], the results get even more interesting. Assuming annual rebalancing and withdrawal amounts consistent with actual inflation, the more diversified portfolio actually led to about an 8% higher portfolio value by 2010, and about 25% higher by 2013.[3]

What’s more, the gist of the article was that bad stock environments have damaged the credibility of the 4% rule. The authors purposefully picked the time period, when the market moved from close to an all-time high in 2000 to a very deep low in 2009. Going forward, and given today’s low interest rates, it’s more likely that below average bond returns will present a more significant challenge to the 4% rule than volatile stock markets.

The 4% rule is just a guideline. It’s not set in stone. At Woodward Financial Advisors, we recognize that our clients’ financial goals aren’t necessarily consistent on a year-over-year basis, and that their goals change over time. In order to achieve those goals, it’s important to construct well-diversified portfolios covering more than just two asset classes, and to rebalance those portfolios according to a judicious schedule. Otherwise, we’d just be twiddling our thumbs.

[1] Calculations performed using DFA Returns 2.0, Dimensional Fund Advisors. Calculations are pre-tax and gross of fees.

[2] 60% Stock: 15% S&P 500 Index; 15% Russell 1000 Value Index; 8% Russell 2000 Index; 7% Russell 2000 Value Index; 8% MSCI EAFE Index; 2% MSCI EAFE Small Cap Index; 2% MSCI EAFE Small Value Index; 3% MSCI Emerging Markets Index. 40% Bonds: Barclays Aggregate US Bond Index. Investors cannot invest directly in an index. Past performance is not a guarantee of future results; current performance may be higher or lower than the performance reported.

[3] Calculations made using DFA Returns 2.0; Dimensional Fund Advisors. Calculations are pre-tax and gross of fees.

About Ben Birken

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