The 4 Percent Rule
Before discussing real estate investments or retirement portfolio income withdrawal strategies, I need to go over the 4% rule. I have briefly mentioned the 4% rule in previous posts, but in future posts this rule will be central to many topics. It is very important to understand this simple concept.
The 4% rule refers to the “4% Safe Withdrawal Rate” (SWR). The SWR is designed to answer the question “How much can I withdraw from my portfolio each year to be reasonably certain I will not exhaust my retirement assets?”
There have been several studies the last 20 years that conclude that a retiree can withdraw about 4% of their retirement asset base in the first year of retirement (increased each year by inflation) and have a greater than 90% chance that their retirement assets will last at least 30 years regardless of future market performance. The 4% withdrawal amount includes dividends, interest, and, if necessary, principle. Any income taxes or investment management fees must be taken out of this 4% withdrawal figure. The different studies vary somewhat on the details of the actual SWR, but most of the studies conclude that a 4% withdrawal rate will support a 30 year retirement over 90% of the time. For planning purposes, it is okay to use 4%. However, if you have a family history of longevity or you are planning to retire in your 50s, you may need to assume a lower withdrawal rate than 4%.
How do you apply the 4% SWR? As an example, let’s assume you have a total financial portfolio of $800,000 (i.e., all liquid assets dedicated to funding retirement whether in retirement accounts or other accounts). The 4% SWR says you can withdraw $32,000 (4% of $800k) in the first year of retirement and increase the $32,000 by the inflation rate each year thereafter. So if inflation is 3% per year. The 2nd year’s withdrawal would be $32,960, the 3rd year’s withdrawal would be $33,948, and so forth. These withdrawals are maintained regardless of how the original $800,000 portfolio performs. If you have any employer pensions or social security income, these annuity payments would be added to the withdrawal amount.
One reason I manage my own money is that money managers charge at least 1% per year to manage your retirement assets. An $800,000 asset base would cost at least $8,000 in management fees per year. $8,000 is 25% of the $32,000 withdrawal that is allowed by the 4% SWR. I cannot afford to give up that much retirement income, especially for something I can do myself.
One may ask, if the long term average market return is about 7% to 8% (assuming a good fixed income allocation), why can you not withdraw 7% of your portfolio per year? The reason for this is 3 words, “sequence of returns.” To illustrate the importance of sequence of returns, let’s assume we have two identical portfolios in every way. Even their average rate of return is the same, 8% per year for 30 years. If you assumed a 7% withdrawal rate, it is possible that one portfolio could be totally exhausted after 20 years and the other portfolio could be larger than its original size after 30 years. How is this possible? It is possible due to each portfolio’s “sequence of returns.” The most important factor in how long your portfolio will last is the returns it experiences in the early years of your retirement. Even though each portfolio averaged 8% return per year, the portfolio that was exhausted early had its down years in the first few years after retirement. The 7% withdrawal rate was too large to allow this portfolio to recovery from its early down years. The portfolio that was intact after 30 years had its down years in the 2nd half of the 30 year period. This means the portfolio had gotten so large in the early years that the 7% withdrawal rate did not affect the portfolio balance even when it started to experience its down years later on. This is why the 4% withdrawal rate is lower than the average long term portfolio returns of 7% to 8%. The 4% allows for market down years in the first few years of retirement.
If you are interested in learning more “inside baseball” about the 4% rule, you can read more about it on “The Retire Early Home Page;” click here to read several articles discussing the 4% SWR concept and related topics.
I will discuss some variations to the 4% SWR in future blog posts.
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