The 4 Percent RuleSubmitted by Mission Financial Planning on March 5th, 2013
The Wall Street Journal’s recent article titled Say Goodbye to the 4% Rule is one of a number of articles in recent years questioning the validity of the rule of thumb that 4% of total return is the “best” number for withdrawals from retirement accounts.
The article offers three strategies, some better than others, for creating retirement cash flow, but the common flaw at the core of those three strategies is the same one that we believe to be at the core of the 4% rule – the risk of damage done by a withdrawal of principal during a down year, particularly if early in retirement.
It is important to understand the flaw in the classic rule of thumb: the 4% in the original study was taken from the portfolio’s total return. Inevitably there will be years that a portfolio’s total return will be lower than the 4% withdrawn for income. When investments are liquidated to cover the withdrawal during a down market, losses are locked in, and the remainder of the portfolio has to come back farther just to get back to “break even”.
In any given year, particularly in the early years of retirement , the volatility risk is too great to risk a required liquidation of the core portfolio for income creation.
To talk about alternate strategies, let’s start with the obviously best strategy – not mentioned in the Wall Street Journal because of an assumption that most investors must eventually invade principal: Set aside enough money to be able to live off the actual income generated by dividend stocks and fixed income investments. With the predictable income of a laddered portfolio of individual bonds paired with quality dividend paying equities, the principal (assuming a big enough portfolio) doesn’t need to be invaded in a down market.
In this optimum scenario, the investor would be living off the income from individual bonds (important: should not be a bond fund), and if dividends are not needed for income they can be reinvested. Assuming the equities increase in value (through modest growth of the original shares or growth plus reinvestment), “excess” equity holdings can be sold at opportune times to buy additional bonds, potentially increasing income. Laddering the bond maturities allows the portfolio to follow changes in interest rates, although changes to the bond allocation’s income will lag rate changes in the market.
For most people planning their retirement, taking a strict income only approach is not practical because their nest egg isn’t big enough. When the need to invade principal is inevitable, Mission Financial Planning will work with your investment manager to create variations of an income only strategy that are more prudent than a typical total return philosophy.
The plan for creating retirement income that will prove most successful will:
⇒ adjust as the cost of living changes,
⇒ allow access to principal in an emergency situation,
⇒ allow a shift in investment philosophy if the markets or personal situation changes,
⇒ limit “locking in” losses in a down market,
⇒ adjust for the various stages of retirement spending,
⇒ and ultimately, provide sufficient retirement income, sustainable throughout one’s lifetime.