- Our Services
- Publications & Video
- Client Login
The 4% RuleSubmitted by Townsend Asset Management Corp. on October 4th, 2016
Imagine you are driving and get totally lost. You have no map and no GPS signal. You’re sitting at a rural crossroads and wondering which direction to take. Fortunately, a local person comes by and informs you that to get to your destination you need to take the road to your right; and relieved, you follow his advice. Unfortunately, twenty miles later you arrive at a fork in the road and are unsure which fork to take. Does this new dilemma make the original advice wrong? Of course not – it just means you have many decisions to make along your journey.
The driver’s confusion reminds me of the criticism I often see leveled against “the 4% Rule,” which is just a rule of thumb designed to give people a rough idea of how much to withdraw from their investments during their retirement years. It was never intended to be a detailed roadmap of every twist and turn as you drive along the retirement road. It was simply an initial starting point at your first crossroads, pointing you in the right direction.
Let’s dig into “the 4% Rule” a bit further
Imagine you are in your first year of retirement and have managed to accumulate $1,000,000 in various savings and retirement accounts. How much can you withdraw each year without eventually running out of money? The 4% Rule suggests that in your very first year you withdraw 4% of your nest egg, which equals $40,000. Of course, you may also be receiving Social Security or pension income in addition. Now, the $40,000 is just for your first year. Thereafter, you adjust this amount each year as the cost of living might be increasing with inflation. So, the second year you might withdraw $41,000 and the third year you might withdraw $42,000, etc. As you see, the 4% calculation is only made for year one, with future adjustments in the dollar amount tied to inflation.
The 4% Rule was developed with a 30-year retirement period in mind, which is adequate for the average person, but obviously not for everyone. It also assumes a person’s retirement investments are a mix of both stocks and bonds, and that historical rates of return and inflation rates continue. The 4% Rule is not a guarantee, but simply suggests a reasonably high probability of a portfolio lasting for a 30-year retirement period.
What if future rates of return are much lower than historical returns? After all, interest rates have been near-zero for a long time. What if your particular investments don’t perform as well as the overall market? What if you retire at a particularly bad time, such as 2007-2008, when the stock market dropped significantly? What if you live much longer than average or have some unusually high expenses that cannot be avoided?
Well, those are all great questions that might need to be considered and factored in. You will, no doubt, need to tweak your withdrawals along the road. While there may be periods when you get no pay raise and must tighten your belt, there may also be periods when you can pay yourself a bonus and withdraw and spend more!
Obviously, starting with a lower withdrawal rate, such as 3%, would help sustain your portfolio even longer – if your budget allows for a smaller withdrawal. But the 4% Rule is still a useful benchmark at the beginning of your retirement travels. It does not tell you about every future fork in the road you will face, nonetheless it at least points you in the right direction.
Gerald A. Townsend, CPA/PFS/ABV, CFP®, CFA®, CMT is president of Townsend Asset Management Corp., a registered investment advisory firm in Raleigh, North Carolina. Email: Gerald@AssetMgr.com