The End of the 4% Rule?
There's a rule of thumb that's pretty well known to retirement planners: the 4% rule. It states that if you spend 4% of your capital in your first year of retirement, you can go on spending that much — and even adjust it for inflation — and you won't run out of money before you die. That rule is starting to look kind of iffy.
The rule has its roots in an older 5% rule that's long been used by university endowments and non-profit foundations. If you have a well-diversified portfolio, you can spend 5% of your capital each year and reasonably expect investment returns will grow your capital over time.
The rule works for non-profits and such because they can react to market downturns by cutting spending: making fewer grants, canceling projects, etc. If the market goes down 40%, they can cut spending by 40%. Most households don't have the flexibility to do that — it's not practical to cut your housing, grocery, or health insurance expenses by 40% just because the market was down last year. Hence, the 4% rule, which provides some slack. Since you're spending your capital down more slowly, you have time to wait for the market to recover from a downturn.
Looking at the past
The rule is just an observation: Over the past hundred years you could have followed the 4% rule starting in any year and you wouldn't have run out of money. That's been true because the return to capital has been pretty high, and because downturns have been pretty short.
Until the 1990s you could get most of your 4% just from dividends on stocks — any price appreciation was just a bonus. At the same time, government bonds were returning more than 4% as well. In fact, you could earn more than 4% on cash as well from the late 1970s until just the past 10 years.
The upshot was that it was trivially easy to put together a portfolio that had an average return of well over 4%. You had to be careful to allow for inflation (which was pretty high during the late 1970s and early 1980s), but pretty much any portfolio that held a mix of stocks, bonds, and cash was going to return enough over 4% that following the 4% rule worked fine.
Looking at the present
Sadly, recent returns have been lower:
- The dividend yield on stocks has been well under 4% for the past twenty years. (For the past ten years, it's been under 2%!) Stock investors saw some price appreciation in the 1990s, but there's been no appreciation since then. In fact, your stock portfolio is probably down over the past decade, even with reinvested dividends.
- The return on bonds held up somewhat better, but has been below 4% for most of the past three years, and below 5% for most of the past 10 years.
- The return on cash dropped below 4% in 2001 (during the dotcom bust). It recovered briefly in 2006, but fell sharply in 2007 and remains near zero.
Looking at the future
The 4% rule only works if two things are true:
- Periods of low returns are short enough that retirees retain substantial capital, even while spending continues based on their old, higher portfolio value.
- The returns the rest of the time are high enough to restore the portfolio.
As the current period of low returns is already long by historical standards, and there's no sign yet of returns rising at all—let alone any sign that returns will rise enough to make up for a decade of flat-to-down market—things don't look good for the 4% rule going forward.
What can you do?
If you're living off capital, you can't depend on any rule of thumb. You need to pay attention to what's actually happening. If your capital isn't growing, you need to hold down your expenses. And if your capital shrinks over a period of years (as it probably has been doing lately), then you need to start cutting your expenses (and probably look for some additional income).
Fortunately, Wise Bread is full of tips on cutting your expenses and on earning extra income.
The 4% rule is still useful as a planning tool. It means that, for whatever level of spending you hope to maintain in retirement, you need about 25 times that much capital. But the key word there is "about." It was never safe to just look at your portfolio level on the first day of retirement, set a 4% payout, and then carry on no matter what the markets did.
Back in the days when only rich people had any capital to speak of, nobody thought about the 4% rule. The rule in those days—for the past several hundred years—was that you only spent income. Everybody knew that spending down your capital—even a little bit of capital—meant that you'd eventually go broke. The 4% rule only works for retirement if you take the position that it's okay to go broke as long as it doesn't happen until after you're dead. Even that is beginning to look a bit optimistic.
If you're building a retirement portfolio, you can still use of the 4% rule for making early estimates of its target size. But don't stop there:
- As you build your retirement portfolio, invest for income. You're much safer spending income than you are spending capital, even if you spend it slowly.
- Pay attention to what your yield actually is, and don't expect your total return to be much higher than your yield. If your actual investments are just yielding 2% or 3%, don't expect some market magic to produce returns that are higher than that.
If you want more information, the book Work Less, Live More, that I reviewed for Wise Bread, has a carefully worked-out analysis of the 4% rule. I also talk about the rule in the context of figuring out how much you can spend in retirement in my post How much do I need to retire? How much can I spend?
The 4% rule was never a magic shield. It was just an observation that a certain payout pattern has worked over a historical period during which the return to capital was reasonably high. There's no law of nature that says that that the return to capital will be over 4%, so there's no guarantee that it will work in the future.