Can I Violate the 4% Rule?
In many of my past posts I have mentioned “the 4% rule.” The 4% rule is a reference to the recommended Safe Withdrawal Rate (SWR) for withdrawing retirement income from one’s financial portfolio. If you are not familiar with the 4% rule, you should read my previous post where I explain the concept. In this post I will discuss if it is possible to violate the 4% SWR in retirement.
As a quick review the SWR is intended to answer the question “When I first retire, how much can I withdraw from my portfolio each year, to be reasonably certain I will not exhaust my retirement assets?” Most of the studies done on this topic generally conclude that when you first retire, if you limit your initial income withdrawal to 4% of your financial portfolio, you will have a greater than 90% chance that your portfolio will not be exhausted before 30 years. The initial 4% withdrawal amount is increased each year thereafter by the rate of inflation regardless of portfolio performance. For most retirees, 30 years will cover their retirement time frame.
I should point out that this 4% SWR is not an exact scientific figure. The studies that have been done on the subject use different assumptions and sets of historical data. I have read several discrete studies that have concluded different SWRs ranging from 3.3% to 4.5%. But most financial planners have settled on 4% as the rate to use for retirement planning purposes. This is why it is often referred to as “the 4% rule.”
Applying this rule means that if in the first year of retirement, a person needs to receive $30,000 per year income from their portfolio, then the portfolio should be about $750,000 on the day this person retires ($30,000/4% = $750,000). For many people, $750,000 is a very large sum of money to save for retirement during their working life. So the question that immediately comes to mind is, “Can a person have an initial withdrawal rate greater than 4% in retirement?
The simple answer is yes; but, like everything else in life, there is a price to pay. In this case the price you pay for violating the 4% rule is that you increase the chance that your portfolio will not last 30 years. It is all about the probabilities of portfolio longevity. The table below presents the 30-year success rate (i.e., the percent chance that the portfolio will last at least 30 years) for various initial withdrawal rates.
Withdrawals Rates and 30-Year Success Rate
|
Initial Withdrawal Rate |
First Year Withdrawal |
30-Year Success Rate |
|
3.50% |
$26,250 |
100.0% |
|
4.00% |
$30,000 |
93.7% |
|
4.50% |
$33,750 |
70.0% |
|
5.00% |
$37,500 |
55.0% |
|
5.50% |
$41,250 |
41.4% |
|
6.00% |
$45,000 |
36.9% |
|
6.50% |
$48,750 |
24.3% |
|
7.00% |
$52,500 |
17.1% |
Calculations based on FireCalc.com algorithm
Assumptions:
-$750,000 initial portfolio balance
-Based on 50%/50% equity/fixed income ratio, rebalanced annually
-Average annual portfolio management fees = 0.50%
-Annual withdrawals are inflation-adjusted based on CPI
How should the data in the table be interpreted? Let’s consider the 7.00% initial withdrawal rate. There is only a 17.1% probability that a 7% initial withdrawal rate will enable the portfolio to last 30 years. In other words, there is an 82.9% probability that if the retiree withdraws $52,500 in the first year of retirement and increases this amount by inflation each year, the $750,000 portfolio will be exhausted before 30 years.
The question one has to ask themselves is, “Do I want to accept the risk that there is a greater than 80% probability that my portfolio will not last 30 years?” It is possible you may not live 30 more years in retirement; however you may live 35 more years. Most retirees will not want to accept this level of risk. The next question is, “what risk am I willing to accept?”
You may be a risk taker and be OK with a 70% probability. In that case, you can have an initial withdrawal rate of 4.5%. If you are an even bigger risk taker, you can opt for a 5% initial withdrawal rate. A 5% rate has a 30-year probability of success rate of 55%. In my opinion, it is foolish for anyone who retires at a normal retirement age to consider a withdrawal rate greater than 5%.
This post summarizes the basic thinking behind 4% as the recommended SWR. There are three other situations where a retiree could increase their SWR above 4% without decreasing their success rate. I will discuss them in the next few posts.
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