Conventional wisdom in the personal finance space tells us that if we want to secure enough money with which we can retire comfortably, we need to assess if that amount can be covered by a 4% return on our portfolio of investments or a 4% “withdrawal rate”. This is colloquially known as the 4% rule of thumb. The rule seeks to estimate a steady withdrawal rate (taking into account inflation) on which a retiree can live comfortably without having to pay too much attention to the ebbs and flows of financial markets.
I’ve addressed the 4% rule before and you can find that article here.
The origins of the rule
The rule is attributed to a financial planner, William Bengen, who came up with it in the mid 1990s, although it was further popularized by the Trinity Study of the late 1990s.
The rule was collaborated by 70-75 years of empirical data. It was based on historical stock and bond returns going back to 1925.
An update of the Trinity study was done in 2009 and concluded, again, that a safe inflation adjusted withdrawal rate was in the region of 4 – 5 %. The updated study again relied on total returns of large-company stocks (S&P 500) and high-grade corporate bonds.
Is the 4% rule still a valid rule of thumb or do we need to rewrite it?
5 Factors that distort the rule and your withdrawal rate
When applying this rule to your own situation, one needs to understand (and this is important so sit up straight and concentrate) that it is not as simple as taking 4% and applying it to your portfolio.
1. The study samples and portfolio mix
The updated Trinity study (check it out here) looked at the following types of portfolios:
- 100% stocks
- 75% stocks / 25% corporate bonds
- 50% stocks / 50% corporate bonds
- 25% stocks / 75% corporate bonds
- 100% corporate bonds
The study also looked at a horizon of between 15 – 30 years.
When looking at the different portfolio make-ups, we can see that the 75% stocks / 25% corporate bonds portfolio works pretty well right up to the 7% withdrawal rate.
Portfolio make up is thus important in deciding on a withdrawal rate.The study did not include an important asset class that I bet all of you reading this either hold or are considering to hold at some stage : Real Estate.
2. Real Estate/Mortgages
Real Estate is much more of an asset class in our portfolios than it might have been decades ago. We generally see 2 types of real estate investments, although there are of course many more.
Rental property and Primary residence investments.
In both of these real estate asset classes, the general trend today (especially given the low yield environment) is to use debt to finance these assets. If you’re including your total outgoings to estimate a withdrawal rate, you may be including a rental or primary residence mortgage repayment.
That repayment will one day come to an end and your outgoings will thus decrease. This will of course then impact your future “safe” withdrawal rate in that you’ll need a higher return in the short-term and you can settle for a lower return later on.
Coming back to the updated Trinity study, we can see that over a 15% horizon, a 50% stocks / 50% corporate bonds portfolio and a 25% stocks / 75% corporate bonds portfolio allows a pretty safe withdrawal rate of 8%.
If we assume most mortgages are around 15 years, we can then conclude that the short-term withdrawal rate can be potentially as high as 8%.
Real estate assets are also assets that can change their use over time. A primary residence may get too big once the kids have left the coop and could then be used to generate an income, while you downsize elsewhere.
All the various portfolios support a safe 4-5% withdrawal rate over 30 years, so a lesser withdrawal rate after the repayment of a mortgage would be warranted.
Downsizing or more appropriately “right-sizing” your primary residence is a great way to decrease financial outgoings, if you have a mortgage, or a way to free up extra financial resources if you have a property that has been paid off fully.
Decreasing your monthly outgoings allows you to decrease your withdrawal rate and allows your investment portfolio to last longer.
Getting money out from a property sale and using only a portion of it to reinvest in your primary residence, and a portion to increase your investments, allows you have a lower withdrawal rate and a longer lasting investment portfolio on which to live.
4. Social Security
Another factor that can influence multi-factor withdrawal rates is social security.
Usually and depending on what country you live in social security starts paying out anywhere between 62 years old and 67 years old or above. So, in this case, up until the start of any social security receipts, your withdrawal rate on your portfolio may be higher and then decrease on reception of the social security monies.
Having an extra income stream means the income stream from your investments can be decreased to cover your living needs.
5. Other annuities or asset sales
Other asset sales or streams of income may increase your investment portfolio and lower your withdrawal rate.
The current yield environment and how it relates to the 4% rule
Back in 2009, interest rates were much higher than they are now. Currently, interest rates are definitely at their all-time historical lows. Look at the below chart from businessinsider and other than the time around WW1, yields have never been so low.
The stock market has also been volatile over the last century, check out the link. Or check out this study that looked at excess returns above interest rates. Currently stocks are performing well above interest rates which is to be expected.
However, over the last 10 years we haven’t on the verge of an all out trade war across the globe with as yet to be experienced impacts. Over the last 10 years, the president of the free world hasn’t been tweeting and a single tweet wouldn’t have brought down a company or an economy of a foreign power.
I think it is fair to say that stability isn’t our strong point right now.
And with a loss of stability, comes the possibility that returns on asset classes like stocks might fall. And if, in addition, interest rates start moving upward, bond prices will fall, leading to underperforming bonds. This is conjecture, and the truth is we don’t really know with any certainty what future returns on stocks and bonds will be.
What then should we be using as a safe withdrawal rate?
Changes in outlook don’t mean you need to entirely dismiss the Trinity study and its update. I am sure when you go back several decades the outlook at each point was fairly different to how things turned out eventually.
We learn from the past and prepare for the future.
The Trinity study and safe withdrawal rates should still be used as a measure of calculating retirement needs versus your investment portfolio balances. In addition, and this is important, you need to future-proof your portfolio against unexpected future occurrences and the possibility of lower returns on certain asset classes, and that means only one thing: diversification.
Working out your own rules is important, and you should realize by now that the 4% rule of thumb needs to be nuanced depending on your current and future situations.
One size doesn’t fit all and neither does the 4% rule.