February 18, 2019

The 4% Rule Of Thumb

“I always like to look on the optimistic side of life, but I am realistic enough to know that life is a complex matter.” – Walt Disney

Let’s break down what is perhaps the most broadly used rule of thumb in financial planning – “You should only pull 4% of your assets as retirement income.”  It’s used so pervasively in the financial planning community that it almost seems like law. And it’s broken. If you read our previously mentioned insights, you may understand how we define a rule of thumb: a principle with broad application that is not intended to be strictly accurate or reliable for every situation.  There is none truer to this definition than the 4% rule.

What does the 4% rule actually mean? This rule is supposed to be an appropriate amount to take each year for a successful retirement, preserving purchasing power and maintaining or growing principal each year. This rule grew up in one of the best bond markets in history where rates were high and falling giving great interest and the bond prices would go up each year. The core assumption of high-interest rates just doesn’t apply today. Now we use fixed income to stabilize a portfolio and if we want more than a 2-3% rate of return, we must rely on equities with values in constant flux.

Here’s how to apply the 4% rule in a vacuum:

  • Take 4% of a $1,000,000 portfolio is an income of 40,000 per year.
  • Portfolio return of 7%
  • $1,000,000 generated an excess of 3% or $30,000.
  • Next year, portfolio is $1,030,000, providing $41,200 in income.
  • Each year income goes up by 3% matching inflation.

This would work great if you had a static portfolio paying out 7% without volatility and constantly growing. 30 years ago you could do that with laddered CDs or bonds. Let’s look at what that would look like today with the same investments paying 2.5% (just higher than the Barclays Aggregate Bond index the last 5 years):

  • Take 4% of a $1,000,000 portfolio, pays an income of $40,000 per year.
  • Portfolio return of 2.5%
  • $1,000,000 generated a net draw down of -1.5% bringing the portfolio down 15,000.
  • Next year, portfolio is $985,000, providing $39,400 of income.
  • Year 2, it’s down to $970,225 providing $38,809 of income. Dwindling each year.

Losing 1.5% per year to spending and another 3% lost to inflation…It’s the opposite intent of the 4% rule, cutting your standard of living a whopping 4.5% per year.

Not everyone is alike! Just as the life of your mother or father is dramatically different from your own life, so will your retirement be very different from theirs. According to the CDC, as of 1900 – at birth, average life expectancy was 47.3 years of age. Think about that for a moment. Who needed retirement in 1900? The idea of not working and enjoying it for decades is a relatively new concept! As of 1950, at-birth life expectancy grew to 68.2 years.  Retire somewhere between 62-65 and the need for retirement income was relatively minimal. And now we’re living even longer and the pressure on our financial assets to last is tremendous! The latest tables are as of 2010, the average life expectancy is 78.7 at birth. At age 65, updated life expectancy is another 19.1 years on average!

Just to throw a wrench into it: What about variables? I illustrated how 4% works great in a vacuum. But what if you want to leave something substantial to the kids? What if you want to bounce the last check on the way to the grave? (Please note the second is a virtual impossibility.)

Here’s our take: we believe the 4% rule is absolutely broken. However, it’s still a decent starting point for conversation and a simplistic guideline as to what our retirement savings goals should look like. Retirement income is a sliding scale that needs to be fine-tuned, over time. Customization should take into consideration the length of distribution(age), wealth, income needs, risk of investments, interest rate environment, market volatility, legacy intentions, health, and many other factors.  As with other rules of thumb, take them for what they are – generic guidelines. Don’t follow a rule of thumb blindly, take the time to work with one of our advisors to learn what you really need for a gainful retirement.

If you would like to learn more about income in retirement, long term portfolios or any of the other topics in this blog, please call Ryan Forster at (913)681-9155 or email ryan@engageadvisors.com.


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