If you’re looking for another reason to question what you read in the financial media, I’ve got one for you.
You made have read over the past year or so about the vaunted “4% Rule.” The 4% Rule was developed by Bill Bengen in 1994. Under the 4% Rule, you can withdraw 4% of your retirement portfolio each year and adjust that amount for inflation.
For example, let’s say you have $1,000,000 at the start of retirement. You could withdraw $40,000 to support your lifestyle over the next 12 months. One year later, your would again withdraw about $40,000, but this time you would adjust the amount for inflation. If inflation was 3%, then you would take out an extra $1,200. You would continue this process for the remainder of your retirement.
The 4% Rule is the most recognized Safe Withdrawal Rate (SWR) for retirees. A SWR is simply the rate at which a retiree can withdraw funds from their investment portfolio, while still maintaining a high probability of not running out of money later in life.
Recently however, many financial experts have questioned the validity of the 4% Rule given today’s market conditions. The argument against the 4% rule essentially revolves around two variables:
- High stock market valuations
- Low interest rates
Both of these variables can augur lower investment returns in the future. And if they do, then it’s possible that most retirement portfolios can not support a 4% SWR.
Morningstar had a report from earlier this year which indicated that 3.3% was a more appropriate figure. More recently, a group of academics published some research that said 2.26% was the right number.
However, let’s pause before throwing the 4% Rule on the ash heap of history. Consider a recent article written by Allan Roth. In his article, Mr. Roth secured a 4% SWR over 30 years using only treasury inflation-protected securities (TIPS).
Essentially, Mr. Roth purchased $100,000 of TIPS over a variety of maturities and was able to secure an inflation-adjusted annual cash flow of about $4,300 per year (or 4.3%).
This isn’t some gimmick either. Anyone could go to their broker and, with a little effort on the trading side, replicate this strategy. It doesn’t cost much to implement. And once in place, it is about as “set it and forget it” as any investment strategy can be.
Not only is the 4% rule alive, but it’s possible to achieve with a high degree of certainty.
You may be asking yourself, “What’s the catch?” And you’d be correct that there is no free lunch here. Using Mr. Roth’s strategy will almost certainly limit your “downside” risk in retirement. For the most part, you wouldn’t need to worry about what the stock market or interest rates were doing.
However, in exchange for this downside protection, you must give up a lot of potential “upside.”
If the stock market returns 15% per year for the next 30 years, you would not benefit from that. Moreover, at the end of 30 years, your ENTIRE investment in this strategy would be gone. There would be no residual amount leftover should you live beyond 30 years.
You would also lose a good deal of flexibility when it comes to cash flow timing. If you had a large expense (such as a home renovation or car purchase), you might be constrained in how you can fund it.
In reality, anyone considering this strategy would be wise to only use it for a portion of their investment portfolio. For example, you might consider combining this strategy with Social Security to provide for your essential living expenses. In effect, you can consider Mr. Roth’s strategy as equivalent to a 30-year period certain, inflation-adjusted, annuity.
In any event, let’s remember that things are not always as bad (or good) as they seem. The 4% Rule isn’t dead. But it’s important to remember that the appropriate SWR for your situation depends heavily on your personal situation and goals.
