(Photo Details: May 2015 at the Kentucky Derby. Is retirement planning like betting on a horse race?)
The 4% “rule” is based on financial planner William Bengen’s analysis of 80 years of historical stock market, bond market, and inflation rate data. By studying every 30-year slice of history within that 80-year period, Bengen showed that a retiree who is able to live off 4% of her beginning retirement nest egg (and that same dollar amount, adjusted for inflation each year), would never run out of money if she lived as long as 30 years. In most cases, our retiree would wind up with money left over. But even in the worst slices of that history, she would not run out of money before her 30 years were up. (As long as she allocated at least 50% of her nest egg to stocks.)
Is the 4% rule really dead? I read that all the time now. I’m not ready to kill the 4% rule just yet.
Sequence of Returns Risk
This is the criticism I read the most. Critics say the 4% rule works fine unless you retire smack dab into a stock market meltdown like we had in 2009.
I’ve never really understood that sequence of return fear. First of all, Bengen’s data included plenty of recessions and stock market gyrations--even the Great Depression—the mother of all risky sequence of returns. It’s hard for me to believe that retiring into one of our more recent recessions would have been worse than having retired right before the stock market crash of 1929!
I retired March 1, 2008, right on the way into a grizzly of a bear market, and guess what? Now seven years later, the market is at an all time high. And it didn’t take seven years to recover either. From the market’s bottom in early 2009, the market marched steadily upward, recovering most of its losses by early 2013.
Yes, it seemed like a long time when I was in the middle of it, but here’s some math: If you retire with 25 times your projected living expense needs that are not covered by other sources (the amount you need to have in order to follow the 4% rule), and allocate your portfolio conservatively 50% to fixed income assets and 50% to diversified stock funds, (the minimum stock allocation required to follow the 4% rule), you are actually holding 12 1/2 years of non-stock related assets when you retire. Assuming even just one-third of those more liquid assets are in cash and shorter term CD’s and bond funds, you have about four years of living expenses available to you without touching your stock investments. That would have been enough, even in this Great Recession to weather the sequence of return storm.
Low interest rate environment
The other argument I read a lot is that the 4% rule doesn’t work anymore because of our low interest rate environment. Well I have yet to understand that concern either. Rates have been very low since I retired. But why would you just look at interest rates? With a proper allocation between stocks and bonds, it’s the total return on my nest egg that matters, not just how much I’ve earned in interest. Since 2008, here’s the total return on the S&P 500 and 10-year Treasuries:
Year S&P 500 T. Bonds
2008 -36.55% 20.10%
2009 25.94% -11.12%
2010 14.82% 8.46%
2011 2.10% 16.04%
2012 15.89% 2.97%
2013 32.15% -9.10%
2014 13.48% 10.75%
The only reason you would care only about interest rates is if you were holding all or nearly all of your assets in cash and short-term bonds. In which case the 4% rule was never intended to work for you in the first place. You have to hold at least 50% in stocks. Of course the rule doesn’t work for a situation that it’s not intended to work for. Ditto with keeping your nest egg in cash under your mattress.
You’re going to die with too much money left over
This one may be true. If you don’t experience a 30-year stretch of time at least as bad as the worst 30 years of the historical data, you die with money left over. Which means that during your life, you unnecessarily scrimped when you could have spent a little more. But you’ll be dead, so I guess you won’t really regret it.
But it’s not really fair to kill the rule just because of this possibility. After all, the rule is simply to give you peace of mind in the worst possible case. Over the years, the guideline has been interpreted more like a commandment: Thou shalt not spend more then 4% (in real terms) of your starting retirement nest egg.
I don’t think it was ever supposed to be a commandment, it was supposed to be a guideline—a good place to start.
Of course, deciding that you actually have enough money to go ahead and retire will always feel a bit like jumping off a cliff. So my next post will give you some ideas to help you build a resilient retirement no matter what your retirement years hold in store.
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