Understanding the 4% rule – Setting your goals
You can’t get to your destination if you don’t know where you’re going
Early in 2019 I made my first trades in my entire life. I think I bought $KO, and $BEN, for no other reason than I knew Warren Buffet like $KO, and they paid a dividend, which sounded nice. I picked $BEN because they have a big headquarters a couple of miles from my house and their stock seemed cheap. I HAD NO IDEA WHAT I WAS DOING.
More to the point, I had no idea where I was going. I didn’t have a goal in mind for my finances. I just knew I had $2500 from a retirement account and I wanted it to grow. Wanting an account to grow is a nice though, but it is hardly a goal.
It wasn’t until earlier this year (2020) that I had an AHA moment. In one of the trading courses I took the instuctor casually mentioned the 4% rule, and how he planned to live off that in retirement. I will do my best to explain the 4% rule to you now, and how it can help guide your goals.
The 4% Rule
The 4% rule simply put means that you should be able to live off 4% of your retirment account every year during retirement, while still growing your account, and not run out of money while you’re retired. Knowing your 4% will give you a target for how much money you will need in your retirement account in order for it to work.
So how do you know what your 4% is?
Everyone’s 4% will be different. It may depend on many other factors like income, savings, pension income, social security benefits, inheritance, rental properties, owning a home, age, etc. My current goal is based on the following criteria.
- I need to own a home outright and not have mortgage payment each month.
- My wife and I’s combined needs will have to be taken into account. (she also has a retirement account we will be able to pull from)
- We won’t have any personal debt. We currently don’t have any CC debt and hope to keep it that way. Just day to day expenses.
- I would ideally like to retire in CA. and not move to a “retirement friendly” state. Just a personal preference.
- Knowing all of that and taking into account inflation, I would think my wife and I would be able to live off $100-120k per year and lead the life we want to lead.
- That means I need to be able to withdraw $50-60k per year from my account.
Now we do math. I know, math sucks. $60/x = 4%/100 – Cross multiply, divide, yadda, yadda, and I come up with x=$1.5 million.
That it’s. That is my magic number. I need $1.5 million in my IRA by the time I retire in order to be able to pull out $60k/year and still grow my account.
Now that I know my magic number I can work backwards and figure out how much money I need to add to my IRA yearly (hopefully you are maxing out anyway) – and how much I need to grow my account every year to reach the goal.
In essence you have given yourself a high level map to your destination. Now you know where you’re going. How to get there…well, that’s a whole lot more complicated.
So why 4%?
We are basing the 4% rule off the notion that a well diversified portfolio exposed to stocks and bonds will give an average return of 6% per year. If you’re pulling out 4%, but making 6% then you’re still up 2% each year. Remember though, that is an average. There are years when the markets may lose money, and there are years where the market may go nuts and make you 10-15% returns. 4% is just a guide.
Beyond the 4% rule
The following section is advice from Schwab and not my own.
However you slice it, the biggest mistake you can make with the 4% rule is thinking you have to follow it to the letter. It can be used as a starting point—and a basic guideline on how much to save for retirement—25x (or the inverse of 4%) of what you’ll need in the first year of a 30-year retirement from your portfolio. But after that, we suggest adopting a personalized spending rate, based on your situation, investments, and risk tolerance, and then regularly updating it.
How do you determine your personalized spending rate? Start by asking yourself these questions:
- How long do you want to plan for? Obviously you don’t know exactly how long you’ll live, and it’s not a question that many people want to ponder too deeply. But to get a general idea, you should consider carefully your health and life expectancy, using data from the Social Security Administration and your family history. Also consider your tolerance for managing the risk of outliving your assets, access to other resources if you draw down your portfolio (for example, Social Security, a pension, or annuities), and other factors. This online calculator can also assist you in determining your planning horizon.
- How will you invest your portfolio? Stocks in retirement portfolios provide potential for future growth, to help support spending needs later in retirement. Cash and bonds, on the other hand, can add stability and can be used to fund spending needs early in retirement. Each investment serves its own role, so a good mix of all three—stocks, bonds and cash—is important. We find that asset allocation has a relatively small impact on your first-year sustainable withdrawal amount, unless you had a very conservative allocation and long retirement period. However, asset allocation did have a significant impact on the portfolio’s ending asset balance. In other words, a more aggressive asset allocation had the potential to grow more over time, but the downside is that the “bad” years were worse than with a more conservative allocation.
- Asset allocation can have a big impact on a portfolio’s ending balance Source: Schwab Center for Financial Research. Assumes a constant asset allocation, a 75% confidence level, and withdrawals growing by a constant 2.19%. Assumes a starting balance of $1 million. Confidence level is defined as the number of times the portfolio ended with a balance greater than zero. See disclosures for additional disclosures on allocations and capital market estimates. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product and the example does not reflect the effects of taxes or fees. Remember, choosing an appropriate mix of investments may not be just a mathematical decision. Research shows that the pain of losses exceeds the pleasure in gains, and this effect can be magnified in retirement. Picking an allocation you’re comfortable with, especially in the event of a bear market, not just the one with the greatest possibility to increase the potential ending asset balance, is important. We think aiming for a 75% to 90% confidence level is appropriate for most people, and sets a more comfortable spending limit, if you’re able to remain flexible and adjust if needed. Targeting a 90% confidence level means you will be spending less in retirement, with the trade-off that you are less likely to run out of money. If you regularly revisit your plan and are flexible if conditions change, 75% provides a reasonable confidence level between overspending and underspending.
- Will you make changes if conditions change? This is the most important issue, and one that trumps all of the issues above. The 4% rule, as we mentioned, is a rigid guideline, which assumes you won’t change spending, change your investments, or make adjustments as conditions change. You aren’t a math formula, and neither is your retirement spending. If you make simple changes during a down market, like lowering your spending on a vacation or for expenses you don’t need, you can increase the likelihood that your money will last.
- How confident do you want to be that your money will last? Think of a confidence level as the percentage of times in which the hypothetical portfolio did not run out of money, based on a variety of assumptions and projections regarding potential future market performance. For example, a 90% confidence level means that, after projecting 1,000 scenarios using varying returns for stocks and bonds, 900 of the hypothetical portfolios were left with money at the end of the designated time period—anywhere from one cent to an amount more than the portfolio started with.
Here are some additional items to keep in mind:
- If you are regularly spending above the rate indicated by the 75% confidence level (as shown in the first table), we suggest spending less.
- If you’re subject to required minimum distributions consider those as part of your withdrawal amount.
- Be sure to factor Social Security, a pension, annuity income, or other non-portfolio income, in determining your annual spending. This analysis estimates the amount you can withdraw from your investable portfolio based on your time horizon and desired confidence, not total spending using all sources of income. For example, if you need $50,000 annually but receive $10,000 from Social Security, you don’t need to withdraw the whole $50,000 from your portfolio—just the $40,000 difference.
- Rather than just interest and dividends, a balanced portfolio should also generate capital gains. We suggest all sources of portfolio income to support spending. Investing primarily for interest and dividends may inadvertently skew your portfolio away from your desired asset allocation, and may not deliver the combination of stability and growth required to help your portfolio last.
- The projections above and spending rates are before asset management fees, if any, or taxes. Pay those from the gross amount after taking withdrawals.
Stay flexible—nothing ever goes exactly as planned
Our analysis—as well as the original 4% rule—assumes that you increase your spending amount by the rate of inflation each year regardless of market performance. However, life isn’t so predictable. Remember, stay flexible, and evaluate your plan annually or if significant life events occur. If the market performs poorly, you may not be comfortable increasing your spending at all. If the market does well, you may be more inclined to spend more on some “nice to haves.”
The transition from saving to spending from your portfolio can be difficult. There will never be a single “right” answer to how much you can spend from your portfolio in retirement. What’s important is to have a plan and a general guideline for spending—and then adjust as necessary. The goal, after all, isn’t to worry about complicated calculations about spending. It’s to enjoy your retirement.