The Problem with the 4% Rule

December 21, 2020

When people invest - and they focus on eye-popping returns- they forget a very simple fact:

Ultimately - at some point - you will need money for the day when you are no longer working. 

The correct question is: 

How much do you NEED  - for 20, 25, 30 years or more - in retirement?

That’s a much trickier question than how to Make 1,000% gain with THIS stock. 

So … One way that people answer this question is with something called the 4% rule. 

Which means  - in year one of your retirement, you withdraw 4% of the balance - and from then on, as the portfolio value changes, due to growth, withdrawals and inflation - you continue along with that 4% level of withdrawal.

Sounds reasonable, right? 


There are possibly some issues with that - BUT: The bigger point is: You HAVE to know how much you can withdraw every year. You can’t guess.

So what factors go into this?

  • Accounting for growth, 
  • for inflation
  •  and to have a portfolio that’s aligned to your time horizon and risk tolerance in the first place. Not some willy nilly collection of STUFF that you like because “it’s done well!” 

And I know the thought process here: It’s doing well, so I’ll keep it and when it stops doing well I’ll sell!

Well, that sounds easy doesn’t it? But it’s like all those things that sound easy - if it were, everybody would do it - bada bing, bada boom, and nobody would EVER lose money in the market or own a poor performing investment. 

So that’s where it’s so important to have a plan, and where the 4% rule comes in. 

But here’s a problem with just saying, “I’ll withdraw 4%.”

For starters, that assumes that a portfolio is properly allocated to accommodate for a client’s risk tolerance, time horizons and goals. But, as I just mentioned, the overwhelming majority of portfolios are just a bunch of stuff all cobbled together - for a lot of reasons- but there’s no purposeful strategy behind it. 

In addition, you have to be cautious about today’s situation, with interest rates being kept near zero through 2023 - that means the yield from your bonds will be lower - Falling interest interest rates make bond prices rise and bond yields fall.

That DOES affect the income your portfolio generates.

You might not remember, but there WAS a time, way back in the past, when bonds were considered SAFE! There was the so-called “widows and orphans” portfolio - which consisted of bonds, and was designed to be low risk.

Today, and for a long time, the risk of bonds has been that you will NOT keep up with inflation and will not generate the return you need for retirement. 

So all of this relates back to simply withdrawing 4% every year.

You cannot just throw this into a spreadsheet and think you’ve done your job - this is a job for a REAL financial planner - and not just one who is really an insurance salesperson whose plan shows how you need to buy an annuity.

Another problem with the 4% rule is the reality of spending. 

I can’t tell you how many times a client has nodded in agreement when I’ve presented a financial plan with spending levels they can afford- all through retirement , but later - maybe weeks maybe months - I’ll hear that the client made a big financial decision that was nowhere in their plan. 

We could easily have run the numbers to get a better understanding, but clients - like everyone -else -  can exercise their freedom of choice! That includes freedom to make unwise financial decisions. 

Don’t be that person!!!! Find a fiduciary planner and work with them!!

Now, I totally understand: Legit spending needs pop up. Maybe you need a new roof or that shiny new Tesla sooner than you thought. Maybe you need to take some personal money and invest it into your business. Plenty of examples like that happen all the time, that could throw the 4% rule into disarray. 

So where does that leave you, if you are planning to retire soon, or are retired, and you want to understand how much you can spend, and how much you must have invested?

It keeps coming back to that plan, my friends! 

Start with a comprehensive financial plan that evaluates all aspects of your financial situation. That will give you a baseline of how much you will need, and how much risk you’ll need to take, to generate the necessary return. 

Should you incorporate the 4% rule? Maybe, but it shouldn’t be your default starting point.

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