The 4% Rule

The so called "4% Rule" has long been considered a safe “rule of thumb” for income distribution during retirement.

Here’s how it works: An individual could withdraw 4% of their retirement date portfolio value, adjusting this amount for inflation in subsequent years and sustain those withdrawals through 30 years, using a diversified portfolio with around 60% stocks.

There’s always debate amongst financial advisors about this. Some will argue that it’s too high, others too low. Many will say that asset allocation has become more sophisticated in the last few years and disciplined rebalancing allows a higher rate of withdrawal. I had one advisor acquaintance tell me that 3.85% was a more accurate and reliable number and spent 20 minutes attempting to prove it to me. It was the longest 20 minutes of my life.

In my opinion, both sides of the argument are missing the point.

The 4% rule is really just a good starting point for planning cash flow in retirement: just as a sailboat navigator plots a course to the next destination and starts out sailing to that plan. The navigator knows for sure that course corrections are going to be needed based on wind, weather, currents and the occasional emergency. But without an initial plan it’s impossible to measure progress.

On a simple level: say inflation is 2% and you need 4%, your portfolio should be aimed at a net return of 6%.... Easy!

Well, it’s never quite as easy as that, but you can see where I’m going. Having set up your well-diversified portfolio, I can guarantee you that conditions will change. Interest rates, equity returns and your circumstances will all change through time and adjustments and rebalances to your portfolio will need to be made accordingly. However, if inflation starts to accelerate through the next few years—and there’s every reason to believe it will—the 4% rule will become a more important navigational tool. What we are talking about here is the difference between nominal and real rates of return. The inflation-adjusted real rate of return is crucial to maintaining buying-power: ask anyone that lived through a period of high inflation on a fixed income!

The bottom line, “setting it and forgetting it” is a recipe for disaster as so many retired or near-retired people discovered in 2000 and 2008.