A Better Approach to Retirement Income Than the 4% Rule

The most common question we get from retirees and pre-retirees is, “How much money can I spend each year in retirement without running out?” It makes sense that this is a big concern for retirees because resources are limited and there are so many unknowns. 

The 4% Rule is an attempt at a “one size fits all” approach to prevent running out of money. It refers to a withdrawal rate from a portfolio, on a yearly basis, where a retiree can guarantee they won’t run out of money over 30 years. 

For example, let’s say a retiree has a $1M investment portfolio that they’re going to start withdrawing from to fund their retirement. The 4% rule says that they will need to start with a $40,000 per year withdrawal from a 60/40 investment portfolio, with a 3% a year inflation rate adjustment, to guarantee that they don’t run out of money. This rule of thumb may eliminate the risk of not running out of money, but also holds a very high risk that you will underspend and end up with a large portfolio after 30 years.

The chart above shows some historical results of the 4% rule and the portfolio value when a retiree started their withdrawals in a given year. As you can see, in many years, the retiree is left with a large portfolio after 30 years. But if you refer to the retiree who started their retirement in 1966, the 4% withdrawal rate barely got them through the 30 years. The key takeaway here is that the “one size fits all” approach comes with a huge range of possible results and will not satisfy the goals of most – if not all – retirees. 

The reason for this wide range in results is due to what is called “sequence of returns.” This refers to the ups and downs that we know are the reality of the market while you are taking withdrawals. This also explains why we can not simply use an average return assumption along with a simple withdrawal percentage for spending. 

From 1970 to 1999, the S&P 500’s average return was 14.89% annually. If we used that yearly average return and withdrew 8% of our portfolio every year, we not only would easily hit the 30 year goal but we would be left with over $26M! Now let’s use the same example but use the actual returns in the years they occurred. 

Here you can see if we use the actual returns (that average out to 14.86%) we will have a much different result. A difference of $22M over the 30 years! Those who are using these average blanket assumptions will likely be way off their expectations in the end. Let’s take this idea a step further and see what happens if we intervene and cut out spending in two of the years when the market is down. 

If we simply cut out spending in 1973 and 1974, we will see an increase of about $6M after 30 years! Now we know we can’t just stop spending in some years, but I show this to prove the importance of a spending plan and how dynamic successful retirement spending and planning can be. The portfolio, the amount you spend each year, and when you spend is extremely important – if not more important – than the actual investment portfolio performance. 

The 4% rule and its “one size fits all” approach can help you if your only goal is to simply not run out of money. With that said, proper planning and strategy tailored to each retirees specific situation will allow them to greatly increase withdrawal rates to fit their retirement spending goals without the anxiety of whether they will outlive your money. If you have some concerns about outliving your savings, or have any other questions concerning a successful retirement, set up a free consultation using the link below. We are happy to help in any way we can.