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Understanding the Four Percent Rule

13 Oct

Question:   Is the 4.0% rule an appropriate guideline for determining the amount of savings a retiree should spend each year?

Background on the 4.0% rule:  Under the four percent rule (as I understand it ) the retiree’s expenditure in her first year of retirement is four percent of wealth in certain accounts.  It is more difficult to apply the 4.0% rule to total household wealth because house equity, a major component of wealth is not liquid.  (The application of the 4.0% rule to total wealth including house equity would at some point require the sale of the home.)

Whether strict adherence to the 4.0% rule leads to a smooth, stable, and sustainable consumption pattern for the household does  not depend solely on average asset returns or average inflation.   The timing of returns and the timing of inflation are also important.

A sharp decrease in returns at  the beginning of retirement could lead to a relatively quick depletion of assets if not accompanied by a decrease in spending.  By contrast, a sharp increase in returns at the beginning of retirement could allow retirees to spend more than allowed or provide a bequest to heirs.

The four percent rule could prove inadequate for workers who are planning to retire in 2017 or 2018 for two reasons.   First, both nominal and real interest rates are very low.   Second, stock valuations are currently extremely high.  Portfolio returns will fall precipitously if interest rates rise and stock prices fall.

Illustrating the 4.0% rule:  The simulations of whether the four percent return will lead to a successful retirement rely on two assumptions — the rate of return on assets and the inflation rate. Our model assumes that the retiree starts spending four percent of assets at retirement and continues to spend at this level in real terms adjusted for inflation.   The output of the model is the number of years (if ever) before the retiree spends all retirement funds.

We consider four scenarios — (1) 2.00% returns and 3.0% inflation all years, (2) 4.0% returns and 3.0% inflation rate for all years, (3) a -20% return the first year followed by 2.0% returns and 3.0% inflation, and (4) -20% return the first year followed by 4.0% return and 3.0% inflation.

Note that scenario two is better than scenario one because returns are higher in the second scenario.

Scenario three is similar to scenario one except for the fact that the market collapses in the first year.

Similarly scenario four is similar to scenario two but for the first-year collapse in asset prices.

The table below presents the number of years it takes for the person to deplete all assets using the four percent rule.

Adequacy of resource for 4% rule under four scenarios
Shock Return Inflation Rate Year Balance goes to $0
None 2.00% 3.00% 23
None 4.00% 3.00% 30
-20% first year 2.00% 3.00% 19
-20% first year 4.00% 3.00% 23

One bad year of returns in the first year of retirement resulted in a 7 year reduction of years with assets in the high return situation (simulation two minus simulation four) and a reduction of four years of assets in the low-return scenario (simulation one minus simulation three.)

The number of years prior to total depletion of assets among the four scenarios ranges from 19 years (scenario three) to 30 years (scenario two.)

 

Concluding Thoughts:

I suspect that these calculations understate the financial risk associated with adherence to the 4.0% rule, in general and in the current economic and financial situation.

The bad scenarios presented here involve a first year of retirement where the portfolio falls by 20 percent.   The collapse could be larger or more last more than one year.

President Trump believes that the the situation in Korea is the calm before the storm.   The same could be said for our financial markets and our economy.

The market is peaking.   The financial advisors and experts want to keep you fully invested argue that the market can run upwards for at least a few more years.   The more reputable analysts acknowledge that the valuations are high.   Long term interest rates remain low but when they rise (and they eventually will rise) bond prices fall.  The simultaneous collapse of bond prices and the reduction in stock valuations could will eventually lead to large losses at the beginning of retirement for a cohort of workers.

Some analysts suggest that investors who use the 4.0% rule should maintain a larger portion of their portfolio in equites.  I disagree.  The worse case scenario for the 4.0% rule involving poor stock and bond returns in a period of inflation actually occurred during the 1970s when inflation rose and stocks fell.   Luckily retirees in the 1970s had traditional pension plans that were not tied to the market.

President Trump believes that the the situation in Korea is the calm before the storm.   The same could be said for our financial markets and our economy.   I don’t believe the current calm before the storm will last.

 

 

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