Revisiting the 4% Rule
In the last couple years, I have been pondering this question, whether the 4% rule was still valid in the new investment environment going forward in the 2020s. I first wrote about the 4% rule in one of my first posts on this site in 2011 (you can read that post here). If you do not want to read my entire earlier blog post, I will summarize it here for you.
The 4% rule refers to the “4% Safe Withdrawal Rate” (SWR). The SWR is designed to answer the question “How much can I withdraw from my portfolio in the first year (increased by inflation in each subsequent year) and be reasonably certain I will not exhaust my retirement assets over a 30-year retirement period? There were different studies conducted in the 1980s and 1990s that vary somewhat on the details, but most of the studies conclude that a withdrawal rate of about 4% will support a 30-year retirement over 90% of the time. Thus the 4% Rule was born.
I also talked about the importance of the 4% rule as a planning tool in my ebook, “Charting an Early Retirement,” published in early 2017. At the time I published this ebook, the Federal Reserve Bank was in the process of raising short-term interest rates, so it appeared we may be getting back to normal interest rates. But that period of rate tightening, for some reason, stopped in December of 2018. But, regardless of the reason for stopping, the Covid-19 pandemic that spread across the globe in early 2020 required the Federal Reserve to lower rates to combat the economic damage caused by the pandemic.
A quote from a section of my ebook, “In recent years, due to low yields on fixed income assets, some retirement professionals have questioned whether the 4% rule is still a good rule of thumb for an initial SWR………If our current low interest-rate environment looks like it may continue indefinitely, a lower SWR may be necessary.” The current Fed short-term interest rate is currently right at 0% and the Federal Reserve recently put out a statement that they do not see the Fed rate increasing before the end of 2023. So, as I mentioned in my ebook, it does look like the low interest-rate environment may, indeed, continue for many years. As such, I think someone retiring today should consider a lower initial SWR.
Before writing this post, I did some web research on the 4% rule to review the latest opinions of financial planning experts on this important financial planning concept. Many were in agreement with my thoughts that the 4% rule may need to be updated, but I was surprised that there were many (several whose opinions I respect) who thought the 4% rule was still valid.
The financial experts who thought that the rule was still valid seem to have a common answer supporting their opinion. That answer is, when interest rates are lower than average, the solution to maintaining the 4% SWR is to increase your equity allocation from 50% to 60% (a 50% to 60% equity allocation was assumed in most of the original 4% SWR research) to, perhaps, a 70% to 75% equity allocation. The thinking is the higher equity allocation should provide a higher return from the equity portion of the portfolio to make up for the lower yields currently available in the fixed-income part of the portfolio.
Although increasing the equity allocation might allow one to continue using the 4% SWR, this solution surprised me. Increasing your equity allocation increases your portfolio volatility making it psychologically more difficult to maintain your target equity allocation in volatile markets. This change also increases your portfolio’s “sequence of returns risk” in the early years. (NOTE: two portfolios can have the same 30-year average annual return; however, the portfolio that has its lower returns in the early years is at greater risk of being 100% exhausted before 30 years. This scenario is referred to as ‘sequence of returns risk’). For most retirees, I think increasing one’s equity allocation is not the way to go.
As I have stated many times on this blog and in my ebook, selecting and maintaining the proper portfolio equity allocation that matches an investor’s risk tolerance is one of the most important concepts in retirement investing. Rather than increasing an investor’s equity allocation above their personal comfort zone, I believe, it is better to choose a lower initial SWR. This choice will, unfortunately, require the retiring investor to have to save more funds to maintain the same spending level. But I think this is better than getting too far outside your investing comfort zone as the fear in volatile markets will make it difficult to maintain your equity allocation and hurt your long-term portfolio results.
There is another reason why increasing the equity allocation in today’s market may not be a good solution to make up for the lower returns in today’s low interest rate environment. The equity markets today are, historically, considered extremely ‘over-valued.’
As of this date with the S&P 500 Index at about 3660, the Price/Earnings (P/E) ratio for the index is about 31. This is almost twice the long-term median P/E ratio of about 17 for the index. Although it is certainly possible that the markets can go higher for a while longer, it seems to me that, at least in the near term, there is more downside risk to this market than upside potential. With an over-valued stock market and historically low interest rates for the foreseeable future, I think an investor, retiring today, who wants to maintain a greater than 90% chance that their portfolio will not be exhausted in 30 years, should consider a lower initial SWR.
So, what would be an appropriate SWR in today’s investment environment? Well, I am not the expert in this field, So I cannot make any recommendations. However, I will provide a web link to an August 2020 Morningstar interview on this topic with Wade Pfau. Mr. Pfau is, in my opinion, one of the top experts in the field of retirement income planning. In the interview, Mr. Pfau answers this question and also discusses other possible income strategies to consider in today’s environment.
Here is the link to the interview with Mr. Pfau.
NOTE: In the interview when they mention ‘required minimum distribution rules,’ they are referring to the IRS’s RMD rules for taxable IRAs and 401(k) accounts that begin at age 72. I thought this approach which, in the interview, they are talking about applying to one’s entire portfolio, was a rather novel and interesting approach to portfolio withdrawals.
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