Can the 4% rule be recovered?

My colleague Catherine Brock recently presented a compelling case of why the traditional 4% rule for retirement savings may be at risk due to the madness that 2020 has brought us. The challenge presented by this article, however, is that the simplest solution – saving more – is easier said than done.

Changing to a 3% or 3.5% rule can make a person’s retirement portfolio more sustainable, but it carries two very big risks. First of all, hitting that target is more difficult than hitting one based on the 4% rule. Second, looking for the larger nest eggs that these numbers require puts you at a greater risk of saving a lot, spending very little and not taking advantage of the money you worked to save during your career. These risks raise a key 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 your principles, you can spend 4% of your retirement portfolio value in the first year of your retirement and adjust your withdrawals for inflation every year thereafter. The return test behind this rule indicates that you have a very strong chance of seeing your money last at least as long as a 30-year retirement.

It has been a great guideline not only because of its relative simplicity, but also because it recommends a target that is within reach of many people. Withdrawing 4% of your starting balance means that you will need 25 times more expenses for the first year. So, if you need your portfolio to cover $ 3,000 per month ($ 36,000 per year), you will need to retire with a savings of $ 900,000. This takes a long time to achieve, but it is usually possible for those who start early and save consistently.

What’s wrong with that?

The main challenge of the 4% rule in the modern world, however, is that it requires you to start and maintain a balanced portfolio of 50% stocks and 50% bonds. With interest rates close to historical lows, bond funds offer almost no return and may risk serious falls as rates rise. In addition, as investors switched to stocks to try to get any chance of positive returns today, this puts pressure on future stock returns, since stocks generally increased faster than profits.

It is this background of a potential world where both stocks and bonds perform below historical rates of return, which makes very smart people question whether the 4% rule still makes sense today. The problem is that changing from a 4% rule to a 3% rule changes that savings from $ 900,000 to $ 1,200,000 to cover the same $ 36,000 in first year expenses. That adds years and / or a lot of extra money for the amount you need to work and save to retire, leaving you even more out of reach.

What else can you adjust?

In addition to saving more money, a different adjustment you can make is having a portfolio with a potential rate of return higher than 50% stocks, 50% bonds, those projected in the original 4% rule. This means having a higher proportion of shares, which means more volatility, but a better chance of obtaining a portfolio return high enough to make the plan work in general.

To give this plan a chance to work, however, you still need to protect yourself against the market crash in the short term. One way to try this is to keep cash for at least five years of the expenses you need to cover and an investment grade bond ladder. This will make you more sure of having the money you need in the short term, when you need it, while giving the rest of your money more opportunities to grow more in the long term in stocks.

Assuming that you are planning your first retirement day to be January 1, 2021, your initial retirement portfolio might look like this:

Table by author.

This structure provides five years of expected spending on cash and bonds, while increasing 4% per year to forecast inflation. This has been higher than inflation for a long time, and pre-planning for that gives you some slack if inflation returns in full force.

Each year, you would spend your money, which is replenished by your maturing bonds. To try to make the structure sustainable, you would plan to collect your interest and dividends and put it in bonds to start composing next year’s rung. In addition, if the market performed as expected, you would convert some of your shares into securities to the top of the next year’s rung.

Obviously, as the stock market is volatile, it will not always perform as expected. If the stock market drastically outperformed, you would add another year (or more) to your bond ladder. If, on the other hand, the stock market’s performance is drastically lower, you would let the bond ladder shrink until the market shows signs of recovery.

If you continue to project 4% inflation, you will need the 2026 rung on your bond ladder to be $ 44,000. Assuming 1% interest on your bonds and a similar yield on your shares, you would get about $ 8,600 in portfolio revenue in the first year. That would leave a $ 35,400 gap that you would have to close by selling shares. This would require their inventories to grow just over 5%. This is below the historical long-term growth rate of the market, which makes it a reasonable long-term goal to consider.

Does this save the 4% rule?

Managing your retirement money in this way would give you a chance to fight to keep your income at a level that the 4% rule would support, but it is certainly not without risks.

One of the main risks is that it uses about 75% of the initial allocation to stocks, which is higher than most traditional guidelines recommend. Although the five-year bond and cash ladder gives you a good opportunity to be patient and let the stock market recover from a crash, it may not be enough time to recover from a really bad one. You can extend your starting ladder to have more breathing space, but this comes at the expense of needing your stocks to perform better to replenish your bond ladder as your assets mature.

In addition, since you are pre-projecting an inflation rate in this model, if inflation comes significantly higher than planned, you may fall short of expectations. Part of this can be managed by spending some of the dividends and interest you receive, but it also comes with the compensation of needing faster growth in your stocks to restore your maturing bond ladder.

Despite these risks, there are good reasons to believe that this adjustment could work. The main one is that the original article that triggered the 4% rule suggests that a 75% allocation to shares also has a great chance of success over a 30-year time horizon.

Choose your trade-offs and build your plan

In today’s environment, it is very clear that there are no certainties when it comes to investing for retirement. The best you can do is to recognize the risks, understand the trade-offs between time, money, potential returns and allocation options, and make an informed choice while planning it.

As you approach the actual retirement date, what you are likely to discover is that you appreciate the flexibility that having a decent sized savings gives you. That way, when you are close to your age and finances to where you want to be, you can make a game time decision based on what is most important to you. Ultimately, that flexibility may very well become the part of your retirement plan that you appreciate most.