Can the 4% rule be saved?

My colleague Catherine Brock recently made a compelling case about why the traditional 4% rule for retirement savings could be jeopardized because of the madness that 2020 has brought us. The challenge presented in the article, however, is that the simplest solution – save more – is easier said than done.

Switching to a 3% or 3.5% rule can make a person’s retirement portfolio more sustainable, but it carries two very big risks. First, it is more difficult to achieve that target than to achieve one based on the 4% rule. Second, you hold the greater chance of saving too much, spending too little and not earning the money you have saved in your career. These risks raise an important question: can the 4% rule be saved?

What is the 4% rule anyway?

The 4% rule is a retirement planning guideline that helps people plan and budget during retirement. Based on its principles, you can spend 4% of the value of your retirement portfolio in the first year of your retirement and adjust your withdrawals for inflation every year thereafter. The back test behind the rule indicates that you have a very high chance of seeing that your money lasts at least as long as a thirty-year pension.

It was a good guideline, not only because of its relative simplicity, but also because it recommended a target that was within reach of many people. If you withdraw 4% of your initial balance, you will need 25 times your first year’s expenses. So if you have to cover a portfolio of $ 3000 per month ($ 36,000 per year), you should retire with a nest egg of $ 900,000. It takes a long time to achieve, but it is usually achievable for those who start early and save consistently.

What’s wrong with that?

However, the most important challenge with the 4% rule in the modern world is that it requires you to start with a balanced portfolio of 50%, 50%, and maintain it. As interest rates are near the highest lows, mutual funds make almost no returns and may run the risk of taking serious declines as rates rise. As investors also switched to equities to try to get the chance of positive returns today, which puts pressure future equities returns as equities generally rose faster than earnings.

This is the backdrop of a potential world where both stocks and bonds underperform their historical rates of return that make many smart people doubt whether the 4% rule still makes sense today. The problem becomes that moving from a 4% rule to a 3% rule shifts that $ 900,000 nest egg to $ 1,200,000 to cover the same $ 36,000 in first-year costs. It adds years and / or a lot of extra money for the amount you need to work and save to retire, and put it so much further out of reach.

What else can you customize?

Besides saving more money, another adjustment you can make to own a portfolio with a higher potential rate of return than the 50% shares is 50% bonds designed according to the original 4% rule. This means you own a higher stock, which means more volatility, but a better chance of getting a portfolio return that is high enough to make the plan work.

To give the plan some work, however, you still need to protect yourself from the downturn in the short term. One way to try to do this is to keep the expenses you need to cover cash for at least five years and an investment grade. This gives you greater certainty that you will have the money you need in the short term when you need it, while giving the rest of your money more chance to grow more in equities in the long run.

Assuming you plan to be your first day of retirement on January 1, 2021, your initial retirement portfolio may look like this:

Table by author.

This structure gives you five years of expected spending on cash and bonds, while building in 4% per year for expected inflation. It is higher than inflation in a long time, and planning ahead will give you a little buffer if inflation should roar again.

Every year you spend cash, which is supplemented by your aging effects. To make the structure sustainable, you plan to collect your interest and dividends and put them into bonds to supplement next year’s run. On top of that, if the market performed as well as you expected, you would convert some of your shares into bonds until you reached next year’s mark.

Of course, since the stock market is volatile, it will not always perform exactly as you expect. If the stock market drastically overperforms, add another year (or more) to your bonds. If, on the other hand, the stock market drastically underperforms, you would shrink the bond ladder until the market shows signs of recovery.

If you continue to project 4% inflation, you should have the amount of 2026 on your bond ladder $ 44,000. Assuming 1% interest on your bonds and a similar return on your shares, you will receive approximately $ 8,600 in portfolio income in the first year. That would leave a $ 35,400 gap to close by selling shares. This will require your shares to grow just over 5%. It is below the historical long-term growth rate, making it a fairly long-term target to consider.

Does it save the 4% rule?

If you manage your retirement money this way, you may have a fighting chance of keeping your target cage at a level that will support the 4% rule, but it is certainly not risk free.

The most important of the risks is that it uses an initial allotment of 75% on equities, which is higher than what most traditional guidelines recommend. While the five-year cash and bond study gives you a good opportunity to be patient and get the stock market recovering from a crash, it may not be enough time to recover from a bad one. You can expand your initial learning to give you more breathing space, but it is at the expense of your stocks to perform better to complement your securities learning as your stocks mature.

In addition, since you are projecting an inflation rate in this model in advance, you could fall short if inflation falls significantly ahead of what you planned. Some of it can be managed by spending some of the dividends and interest you receive, but it also comes with the consideration that your stocks need to grow faster to supplement your outdated bond.

Despite these risks, there is good reason to believe that this adjustment can work. Most important among them is that the original article that sparked the 4% rule suggests that a 75% share award also has a strong chance of success over a period of thirty years.

Choose your compromises and build your plan

In today’s environment it is very clear that there is no certainty if you have to invest for your retirement. The best thing you can do is recognize the risks, understand the trade-offs between time, money, potential returns and award options, and make an educated choice while planning for it.

As you get closer to your actual retirement date, you are likely to appreciate the flexibility you offer with a decent sized nest egg. This way, if you are close in age and finances to where you want to be, you can make a playing time decision based on what is most important to you then. If all goes well, flexibility can most likely become the part of your retirement plan that you value most.