For over two decades, many people have been following the ‘4 Percent Rule’ when it comes to figuring out how much to save for retirement. In this episode of Money Script Monday, Jordan discusses where this rule originated from, the concerns of implementing the theory, and the alternatives to consider when looking at an ideal retirement income strategy.
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Hi, my name is Jordan Arias and welcome back to Money Script Monday. Today, what we're going to be talking about is that 4% Rule. Does it still make sense? We've all heard about it, that if we build our retirement assets, we can take a 4% withdrawal rate, and we'll be fine through our retirement years and never outlive our money. What I first want to talk about is where that 4% Rule came from, then I want to talk about some concerns of the 4% Rule, and then other things to consider as well.
What is the '4 Percent Rule'?
So first, where'd that 4% Rule come from? It was actually done by a financial advisor himself by the name of William Bengen and this study was done in 1994 and what William wanted to look at was just that, what's the comfortable percentage that his clients could take to ensure that they would never outlive their money?
Through numerous backcasting tools, through numerous testing, he came up with 4%.
And what he looked at is that 4% would give us an 80% probability or higher that a client would not outlive their retirement assets by more than 30 years. So it would give them at least a 30-year span and over an 80% probability that they wouldn't outlive their money, no matter market conditions. If markets are up, markets are down, as long as we take out 4%, we would be okay. And we want to look at that and see does that still make sense today. You know, from an advisor that did this study back in 1994, over 20 years ago, does it still apply to you today?
Before we do that, let's look at an example of what that 4% Rule looks like. So if we had an account that was $500,000, we multiply that by our 4% withdrawal rate, that's going to give us $20,000 in the first year.
Now, what William also indicated is we are going to factor in inflation. If we're considering a 2% inflation, for the second year we're not just going to take out $20,000, we're going to take out $20,000 multiplied by 2%. That's going to give us $20,400. And then in the third year, what we're going to do is take the $20,400, multiply that by 2% and it gives us $20,808. And then in the fourth year, we're taking $20,808, multiplying by 2%, it's giving us $21,224.
You can kind of start to see there that we're starting off with a 4% factor, but we're also indicating inflation into there as well, which creates a little bit more of a drag on our contract, all the while assuming that our principle value of $500,000 is either earning high rates of return in the market, and bond rates, or even if there's low returns, we would still be fine taking those withdrawal rates.
'4 Percent Rule' concerns
I want to challenge you to start thinking about your own situation and perhaps ask your advisor some of these questions as well.
(1) Is This 4% Rule Outdated?
You know, this study was done back in 1994. Does that still make sense and does that still apply today? And many would argue that it does not, considering where bond rates are right now, where volatility is, a lot of William's study was factored in on a high percentage of your portfolio being in bonds. And if those rates are different, is that factoring in the same types of average returns that he was getting over 20 years? That's the first thing you want to look at.
(2) Market Downturns
If we've been saving on an annual basis through our working years and we're at a 30-year employment. We've saved the most amount that we possibly can and now we're ready to take that distribution from those accounts. And all of a sudden, there's two negative returns on a back-to-back years, and we're taking distributions, you know, that could drastically affect our retirement portfolio. So much so that it could take a 30-year lifespan and bring it down to 20-years just over those two-year periods.
So that's a big thing to consider. If we're at a fixed 4%, we're not going to waiver from that, and there was a market downturn when we're taking our distribution, that could drastically affect our retirement portfolios.
(3) Large RMDs
"RMDs" are Required Minimum Distributions, and let's say we haven't taken enough distribution from our retirement years, we've been too conservative and we're left with a high account value, then the IRS says you have to take distributions from those accounts, starting age 70 and a half. We could be left with higher tax bills later on in our retirement years because we haven't taken enough earlier on because our portfolios have done well. If we're staying static, that could be a factor as well.
Things to consider
Now, what we want to look at are alternatives to that 4% Rule.
Lower Withdrawal Rate
There have been current studies based off of William's design. Is that 4% still plausible based off of current rates? And based off of current studies, you're looking more around 3.5% to 3% to give you that 80% probability that you'll have a 30-year life span of your retirement assets. That's one thing that you can do is take a lower withdrawal rate than that initial 4%.
Adjust Annual Income
If markets are up, if our portfolios have done well, we can take out more money. And then the same goes to the opposite end. If things aren't going that well and we haven't had the returns that we're looking for, we may have to take out less. Now, the problem with that is, we're going to have a fixed set of income expenses. So, to try to be able to adjust on an annual basis what we're going to be taking out, can become very tricky.
Guaranteed Income Strategies
I challenge you to think about what type of guaranteed income do I have that can cover my fixed expenses on an annual basis that I ensure I don't outlive my assets? You want to think about things like social security income, pensions if you have any. But then there are alternative products out there that give us these guaranteed income structures and more importantly, they still give us liquidity and use of control over that asset. We still have the ability to take out more if need be, or take out perhaps a little bit less, depending on the strategy that we're looking at. But the most important part is that those accounts are going to give you guaranteed income.
Although some can argue that the 4% Rule would work, or some may say that it's too aggressive, or some may say you can take out more, the biggest thing is that if we factored in more of a guaranteed income structure into our retirement portfolio, we're really accomplishing that 4% Rule or 5% Rule, whatever it is, because we know that we're never going to outlive our money because that income is guaranteed for life. And we want to look and focus on covering those fixed expenses.
I challenge you to think about that and to talk to your advisor about what type of income do I have that's absolutely guaranteed, and what type of income do I have that's structured towards market returns and performance? What we've done also is we've included a couple pieces that I encourage you to read. One is focus on the market downturns. That really gives you a side by side comparison if there are negative returns when you start that distribution, how quickly those account values can be drawn down to zero.
That's really the most important thing here is that we ensure that we never do outlive our income. That's what William was trying to accomplish for his clients, and that's what we try to accomplish for our clients as well.
I appreciate the time today, hope you have a great day, thank you very much.