The End of the 4% Rule?

by Philip Brewer on 4 October 2010 10 comments
Photo: Philip Brewer

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:

  1. Periods of low returns are short enough that retirees retain substantial capital, even while spending continues based on their old, higher portfolio value.
     
  2. 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).

ARTICLE CONTINUES BELOW

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.

[Data on stock market returns from Simple Stock Investing. Data for bond and cash returns from the Federal Reserve Bank of St. Louis.]

 

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Guest's picture
Nick

I agree that the 4% rule is still useful to help plan. But if you're nearing retirement age and are close to the 4% rule, it might be wise to work a couple extra years while you are comparably healtier and more employable than realizing when you're 80 that you're about to run out of money. A little gloomy, for sure, but wise to plan conservatively for retirement in my opinion.

Philip Brewer's picture

Working a little longer is one option. Another is arranging to continue to earn some money after you retire. And, of course, there's always the option of being a little more frugal than you'd planned—start your spending at 3.5% of your capital, for example.

You're right that being a little more conservative is the way to go just now—but there are a lot of ways to be a little more conservative.

Guest's picture

Another key component when determining investment withdrawal rates is one's portfolio performance over those first critical years of retirement. If one picks the right year to retire and the market does well for those first couple of years, the withdrawal picture is dramatically rosier than if the market tanks over that same initial retirement period.

Philip Brewer's picture

I've spent the whole three years since I quit working a regular job joking about this with my still-working colleagues. "Boy!" I'll say. "Glad I'm not about to retire!"

Guest's picture
Hondo the bondo

Phil, I think your article provides a realistic approach to retirement planning. Too many financial salesmen promise high, unrealistic returns to "make the sale," instead of encouraging people to live within their means, as you do. However, I think the article makes two mistakes about bond investing.

1. You claim that over the past 100 years, bonds have always had annual yields more than 4%. According to Prof. Robert Shiller of Yale (and the now-famous house price indices), 10-year Treasury bond yields were below 4% from 1881-1911 and from 1926-1957, so two fairly long periods of time. Link to Prof. Shiller's data:
http://www.econ.yale.edu/~shiller/data.htm

2. You mistakenly conclude that the yield on a bond is its only source of return, and that the investor spends all of their income, instead of reinvesting it. During periods in which the yield was greater than 4%, the extra income would likely be reinvested, so it would compound over time. Furthermore, it is unlikely that an investor would own a single bond in their portfolio. Even a simple bond ladder would improve the return, because the investor would be reinvesting maturities and interest income in excess of the 4% rule into the longest "rung" of the ladder, which is above 4% for long periods of time (though also below it, see #1 above).

Philip Brewer's picture

I certainly didn't mean to say that yields had been high for 100 years. Rather, they've been high for the past 30 years or so—from the late 1970s until the recent financial panic. (The link to the St. Louis Fed provides historical bond yields).

Rather, what I want to emphasize is that the bond coupon is pretty much all the return you're going to get over the long term. (During periods of falling rates you can earn higher returns in the short term. But if you're expecting higher returns than the coupon rate, I think you're likely to be disappointed.)

Good point on bond ladders. I actually have a post on the topic:

http://www.wisebread.com/laddering-for-higher-more-stable-returns

Bond yields seem to move in very long cycles. For the past 30 years (my whole adult life) bond yields have been falling. I expect that soon they'll start rising. Once they do so, I expect they'll be in a general uptrend for decades. That has some serious implications for what sort of bond investing will make sense going forward. I talk a bit about that here:

http://www.wisebread.com/when-interest-rates-head-up

Thanks for your comment!

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crash

I semi retired in 2007, and have been supplementing my part-time income by doing an SEPP on the Traditional IRA part of my retirement funds. The SEPP is a bit like test driving the 4% rule for me, since it distributes about 3.2% of the principal every year. 2007 would have seemed like a really crappy time to begin drawing down on the nest egg, but so far, its been working out pretty darn well for me. The fund balance is actually about $18000 higher than it was when I started drawing from it, even tho Ive been taking that ~3% in monthly installments since 2007. Its invested primarily in index funds, a 70/30 split,a mix of US big/midcap/small and international and short/mid long term bonds. I've projected a long term return of 6.5% annually just for planning purposes, but currently I'm running ahead of that target. But I think this article does a good job of emphasizing that the 4% SWR its not a rule, its a guideline; its not a prediction, its a projection, and the ability to be flexible is key.

Guest's picture
Kevin M

Great explanation of the 4% rule.

Note that the 5% used by endowments/foundations is actually the minimum required to be distributed under the Internal Revenue Code. If they fall beneath this threshold, the entity could be subject to an excise tax on undistributed earnings.

http://www.irs.gov/charities/foundations/article/0,,id=137632,00.html
http://www.irs.gov/charities/foundations/article/0,,id=137646,00.html

Guest's picture

Phil,
Good post! One way to deal with extended Periods of low returns is to drastically reduce spending in those years. Maybe go live in Thailand for a few years or something like that.

Philip Brewer's picture

Yes, that's exactly the right thing to do. (Exactly how frugal you need to be depends on just how short your returns fall.)

But the point of the 4% rule was that you wouldn't need to do that. Historically, if you'd retired anytime from the 1920s through 2000 or so, periods of low returns were always short enough—and always followed by periods of higher returns that were high enough—that people could just carry on and they'd still be okay.

Now I'm beginning to worry that the 4% rule is going to fail us, just when a whole lot of people had begun to rely on it.