The Problem with the 4% Rule

Today, I’m going to talk to you about the 4% rule. So, you are probably already familiar with the 4% rule. In my last podcast I talked about all of the things you need to know about what the 4% rule means and many of the misconceptions about it. If you’re not totally familiar about what the 4% retirement income rule means, I would definitely check out the latest podcast. You can also go on Forbes where I write a column and talk about all of the misconceptions and basically everything you need to know about this rule and how to apply it to your own retirement.

Now, having said that, there is a big problem with the 4% rule.

Before I talk to you about that, let’s discuss exactly what it means to be a long-term investor.

A conversation that I’ve had many times over the years is when the market is volatile – maybe it’s dropped 10, 15 or 20 percent – and the clients are a bit worried about the market. They’re worried about the economy, they’re worried that their portfolio is going to decline, they’re worried that they might not be able to retire. They have a lot of questions and they certainly have a lot of anxiety. What most financial advisors do is they try to talk clients off the ledge. They try to talk them against selling in a down market. This is wise and sage advice. There is absolutely nothing wrong with that.

A good long-term investment return is achieved by sticking in there when the market drops, then recovering with the market. The worst thing that you can do is to try to buy and sell, and buy and sell – that always leads to disaster.

One of the things I joke about when I’m talking to clients or giving presentations is I’ll tell people that I can show them how to become a millionaire investing in the stock market. What I tell them is they start with a billion dollars and time the market, and they are almost always going to end up with about a million dollars. So, the joke, of course, is that when you try to time the market, you lose money. This is most likely the scenario that you will experience if you try to time the market, or at the very least, you just won’t get a very strong long-term return.

Of course, as a financial advisor, I am suggesting to you: make sure that you have an investment allocation that makes sense for you, your goals and your risk tolerance. The last thing you want to do is have a portfolio that’s invested in a way where it’s so volatile that the next downturn that we have in the market causes you to be up at night, worried about your retirement nest egg. Make sure that you have a portfolio that makes sense.

Then, the wise advice is to ride out the volatility. If we’re having a down week or a down month – or even a down year – stick with it and hopefully the market recovers and then your portfolio will recover as well. But, there is a caveat here. The caveat is if you are about to retire.

I’d like to think in terms of retirement as a bubble, and the bubble is about five years before you actually retire, and then five years after you retire.

During this bubble, things are a little bit more precarious. When you’re young and you’re saving and earning money, it’s not a problem if the market drops. In fact, it could actually be a good thing that helps you as a saver and as an investor buy more assets less expensively. Well, that’s all fine and good, but what happens when you’re very close to retirement or you’ve already retired?

What happens is, most likely, you have a much larger nest egg than when you were younger. You’ve had all those years to save and you have the benefit of all of that investment performance at your back. And so five years before retirement, most likely, you’ve got a pretty sizable retirement nest egg that you are investing. Couple that with the fact that in a few short years, you’re going to be withdrawing money from the portfolio.

Withdrawing money from a portfolio is very, very different. It’s an entirely different beast than contributing money to a portfolio. It’s a night and day difference. This is where I get to the problem with the 4% rule. Definitely check out my Forbes column if you’re more of a visual learner. I have three charts on there that you’re going to want to have a look at. Let me try to explain this, at least verbally.

Imagine three different scenarios, and I’m going to keep all of the assumptions the same for each of these scenarios. The assumptions that I’m keeping identical are that the average annual portfolio return is 5.5%. What that means is that the average return per year for this portfolio is 5.5%. The other assumption is that the time frame I’m looking at is a 30-year time period. Why 30 years? Well, let’s imagine that you retire at 60 or 65. 30 years puts you at 95. I think that’s a reasonable time period. The third assumption is that I’m starting with a portfolio value of a million dollars. The last assumption is that we’re going to be withdrawing $40,000 per year. With the 4% rule, the rule is actually that you take your starting portfolio value when you retire – we’re assuming, $1 million dollars – and take 4% of that. 4% of a million is (yes, you guessed it!) $40,000. All of those assumptions are the same across all three scenarios.

Scenario 1:

This is what I call a strong start with a bad finish. What do I mean by that? What I’m referring to is investment performance. So, basically, the return of your portfolio. The strong start means that for the first several years, your portfolio when your entire retirement gives you a large and strong return. The first year is at 20%, the second year is at 25%, the third year is a 30% return, and then it goes to 15%, 10%, 9% – basically, it is a very strong start. So, you retire and you’ve had several years of really strong returns. In fact, in this scenario, you’ve had 25 years of positive returns. Then what happens?

As the name describes, we have a bad finish. So, the last five years are abysmal. You have a negative 5% return, negative 10% return, negative 15% return, negative 20% return and in the final year, that 30th year, you have a negative 25% return.

The important thing to keep in mind is that even though you had a strong start and a bad finish if you add up all of the 30 years, your average return each year is 5.5%. That is something you don’t want to forget because that’s the same across all of these scenarios: 5.5% average annual return.

Under scenario 1, what do we notice? Well, basically, this is a really great outcome. Even though those last five years were terrible, your portfolio dropped considerably, you still end up with almost $2.8 million. Remember, you started with a million, you took out $40,000 every single year for 30 years, and at the end of 30 years, you still had nearly $2.8 million in your investment account.

So, that is scenario number 1. It’s kind of scary those last five years, but still, a really strong outcome. Now let’s imagine scenario two.

Scenario 2:

Scenario two is much easier because what I assumed here is that every single year, you had a 5.5% return. There are no negative years. Every year was a simple, straight 5.5% return. So, how do you think this portfolio did at the end of 30 years? Remember, you started with a million.

At the end of the 30 years, after withdrawing $40,000 each and every year, this portfolio had – drumroll, please – a little over $2 million. So, it wasn’t as good as the first scenario, where your investment performance started out strong, but you still doubled your money after 30 years.

It’s a decent outcome. You were able to withdraw money, live on it, and at the end of the 30 years, you still had quite a big portfolio. So far, so good.

Now let’s look at scenario three.

Scenario 3:

This is called bad start with a strong finish. This is just the opposite of the first scenario. Instead of starting really strong and your portfolio doing really well, under this third scenario, we assume that the first five years were terrible. You had a negative 25% return, followed by a negative 20% return, negative 15%, negative 10%, and negative 5%.

Imagine you retire, you’ve had five years of terrible returns, but then, things start to turn around. For the remaining 25 years, you have nothing but positive returns. Okay. So, will this differ at all from the first scenario? Again, the average annual return is still 5.5% — that is the same across all these scenarios.

What happens when you start poorly when the market drops considerably for the first few years? Even though you can have 25 years after that of really strong, solid returns, it’s not enough to make up for those first five years of negative returns. In fact, you may or may not believe this, but you actually run out of money in year 15 – that’s right, you run out of money.

For all of these scenarios, the assumptions were the same. Remember, you start with a million, you take out $40,000 each year, the average annual return is 5.5%. That’s all the same. The only thing that I’ve manipulated in these three scenarios is the timing of those returns.

When you start retirement with negative returns, what happens is your portfolio is not enough.

You get a double whammy, really: one, is you’re withdrawing money; two, is the negative return. So, even though in year six through 30 you have strong positive returns, it’s just not enough to make up for those first few years that had poor returns. So, it’s a big, glaring problem with the 4% rule.

You have to make sure that when you are retiring, you are cognizant about the fact that sequence of investment returns matters. It makes a big, big difference when you’re pulling out money to live on. The 4% rule accounted for that. The whole idea of the 4% rule was that the advisor who ran these numbers was trying to look at what is the minimum return that I can live on and withdraw from my portfolio and not run out of money over a 30-year period. He concluded that it was 4% of the initial starting value of the portfolio. So, it’s important that you really consider that when you retire, your sequence of investment returns matters a great deal.

The big question is what can we do about this? Do we have any control over what the stock market does?

Sadly, no. None of us do.

What does that mean? Are we just at the whim of what the market does when we retire?

Are we just hoping and praying that when we retire, it happens to be a strong return in the markets for the next few years?

We can do more than that. There are different strategies and tactics that we can employ that will mitigate the risk of sequence of returns. That will be a subject that I want to talk to you about in the next podcast.

If you have any questions about the 4% rule or your retirement, I would love to answer them on this podcast. So, please, send me an email at robert@pacificawealth.com, let me know if you have any questions about the 4% rule or retirement. In future episodes, I will be answering all of your retirement questions directly on this podcast. If you have a question, go to askdoctorrobert.com and you can submit your question and I look forward to answering it.

Thank you for joining us for this episode.