Wednesday, May 13, 2015

Can I Trust The 4% Rule in 2015?

Back in 1994 Bill Bengen published the first article on the four percent rule in the Journal of Financial Planning. Little did he know that this article would be the beginning of a thriving cottage industry. Since then numerous academic studies have validated the 4% rule. The most famous is the 1998 Trinity Study published by three professors from that university. Along the way other studies have questioned the validity of the 4% rule in various possible scenarios, including the one that we face today.

The four percent rule states that a retiree can safely draw 4% of the total from a balanced retirement saving portfolio (50% cash, CDs, and bonds, 50% stocks and stock mutual funds) in the first year of retirement. After that the retiree can withdraw an amount equal to that drawn in the initial year adjusted for inflation.


$1,000,000 in retirement savings multiplied by 0.04 = $40,000 that can be spent in the first year of retirement.

Assuming a 3% increase in inflation over year one the retiree can safely withdraw $40,000 X 1.03 or $41,200 in year two.

After 30 years the studies indicate that the retiree should have somewhere between a 95% and 98% chance of not outliving his money. If nominal retirement age is 65, that means at 95 you can still pay your bills.

The obvious major problem with this rule of thumb would appear if a major stock market crash occurred in the first few years of retirement. Be certain not to retire a year or two before a stock market crash. Seriously, I would recommend a more conservative position than 50/50 in the first few years of retirement. If you can live on less than a 4% draw in those first few years, err on the side frugality. Later you can loosen it up a bit.

In the last few days I have read a couple of articles questioning the validity of the 4% rule in our current market conditions. The Shiller Price Earning Index stands near 27. Historically, this is dangerous territory. The Federal Reserve Bank has attempted to recapitalize the banks and rejuvenate the economy with unnaturally low interest rates. This has fueled an asset bubble in stocks. Serious people are predicting total average annual market returns of about 2% over the next decade. Compare this with the normal long term return on equities of 7% after taxes and inflation predicted by Siegel’s constant.

Fixed income investments are nearly worthless, barely offering any protection against inflation. Savings accounts are measured in tenths of a percent. Six month to two year CDs run in the ½% to 1% range. The ten year Treasury, once the gold standard of retirement, barely breaks the 2% barrier. Intermediate term investment grade tax free municipal bonds and investment grade corporate bonds yield around 3%. The Vanguard Total Bond Market fund yields 2.5% with an average maturity of 5.6 years.

You will notice there are no numbers in the last two paragraphs that are equal to or larger than 4%. In normal times capital gains on your stock holdings will protect you against inflation and fixed income investments will provide you safety from “corrections” in stock markets. These are not normal times.

While these articles question the safety of the four percent rule in our current market environment, none of these articles offer any rule of thumb that can replace the four percent rule. One of the authors frankly admits that he can’t suggest anything better, but like this author recommends caution.

I am fond of saying that a rule of thumb is a rule that works thumb of the time. It offers a quick and dirty reality check on your assumptions and your behavior. If you are retired and able to live on the income generated by your portfolio, loosen up a little and enjoy life; maybe give a little more to charity. If you are drawing down more than 5%, you better look for ways to cut your expenditures. If you aren’t retired and you are not sure you can live on 4% of your savings, plus Social Security, plus whatever pension or annuities you might possess, work another year.

Folks! Let’s be careful out there.

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