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Your Personal "4 Percent Rule"

retirement investments

When someone begins to think about retirement, they usually ask themselves at least one question: How much can I spend in retirement without running out of money?

No one knows when this question was first asked, but we do know that Bill Bengen, a now-retired financial advisor, first articulated the “four percent rule” in 1994.  His rule states that a person can drawdown or withdraw up to four percent annually from their portfolio without fear of outliving their money.  Bengen later called this rate the SAFEMAX rate for “the maximum ‘safe’ historical withdrawal rate,” and in 2006 revised it to 4.5% for tax-free entities (nonprofits) and 4.1% for taxable entities (you and me).

How did one person’s idea become so well known?

First, its simplicity is very appealing.  A ‘rule’ becomes a ‘rule of thumb’ because it bears some truth and is easy to remember.  Bengen’s “four percent rule” meets both of those qualifications.

The rule’s popularity grew as financial planners and academics studied its validity and appropriateness in various market environments.  The debate kicked off in 1998 with the Trinity study and it continues today.  The criticisms, comments and variations generated by those studies will be the topic of future posts.  For now, we point out that the “four percent rule” and its variations continue to be popular.

How to calculate your own version of the rule

You can calculate your own rule of thumb to estimate a sustainable withdrawal rate based on your needs and the allocation of your retirement assets.  There are three components to the calculation: withdrawal rate, taxes, and inflation.

Let’s start with inflation first.  Why?  Because the goal of having a “sustainable” annual withdrawal can only be achieved when purchasing power is preserved.  In other words, if the portfolio grows with inflation each year, the withdrawal, in dollars, will grow with inflation.  To keep things simple, I use three percent (3%) a year, close to the 90-year historical average in the United States.

Next, let’s talk taxes.  Withdrawals from a rollover IRA or other qualified plans are taxed as ordinary income.  In a taxable account, you’ll pay taxes on interest, dividends and capital gains.  And, yes, even Social Security is subject to taxes.  To calculate the taxes on your withdrawal rate, determine the average tax rate on your withdrawals.  Easier said than done, of course.  This is one area where the expertise of a financial planner can be helpful and profitable.  For our example, let’s assume a 25% average tax rate.

For the third component, withdrawal rate, you can total up your annual expenses and divide that number into your portfolio value at retirement.

Now, put the three components together!

In this example, if your withdrawal rate is 4% of your portfolio value, your taxes will be 1.33%.  Putting it together with a 3% inflation rate, you can see that your portfolio must grow 8.33% per year for you to maintain your purchasing power while supporting your lifestyle and paying your taxes.

Withdrawal rate         4.00%

Taxes                         1.33%

Inflation                      3.00%

Total annual return    8.33%

Will your portfolio grow that much?

After determining your sustainable withdrawal rate and total annual return requirements, it’s time to think about the mix of stocks and bonds that will provide the average annual return you need.  In our example, you want to know how to achieve an average expected return of 8.33% from retirement through the end of your life.

Here, things get complicated fast.  Here, the criticisms, comments and variations following the Trinity study arise again and give us reason to pause and ponder.  Should we use the 90 years of historical returns on stock and bonds or should we adjust those averages to reflect the current climate of low inflation and interest rates, slow growth, and central bank interventions?  Should you be prepared to reduce your spending during a bear market?  The questions go on and on.

When determining your allocation between stocks, bonds and cash, you want to meet several goals simultaneously: earn an average return as calculated above, be able to weather the storm of a bear market, and have peace of mind about your investments.  At Oasis Wealth Planning Advisors, we are ready to help you reach these goals.