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Understanding the four percent rule

3 Jul

Question:   Is the 4.0% rule an appropriate guideline for determining the amount of savings a retiree should spend each year?

Background on the 4.0% rule:  Under the four percent rule (as I understand it ) the retiree’s expenditure in her first year of retirement is four percent of wealth in certain accounts.  It is more difficult to apply the 4.0% rule to total household wealth because house equity, a major component of wealth is not liquid.  (The application of the 4.0% rule to total wealth including house equity would at some point require the sale of the home.)

Whether strict adherence to the 4.0% rule leads to a smooth, stable, and sustainable consumption pattern for the household depends on asset returns, inflation, and the timing of inflation and asset returns.  A sharp decrease in returns at  the beginning of retirement could lead to a relatively quick depletion of assets.  A sharp increase in returns at the beginning of retirement could allow retirees to spend more than allowed or provide a bequest to heirs.

The 4.0% rule may result in retirees too quickly depleting their resources in the current financial environment where the risk free return is lower than inflation.

https://financememos.com/2013/02/15/chasing-yield-by-investing-in-long-term-bonds/

Illustrating the 4.0% rule:  We consider four scenarios — (1) 2.00% returns and 3.0% inflation all years, (2) 4.0% returns and 3.0% inflation rate for all years, (3) a -20% return the first year followed by 2.0% returns and 3.0% inflation, and (4) -20% return the first year followed by 4.0% return and 3.0% inflation.

We calculate the number of years it would take for the retiree to deplete all assets under the four scenarios.  Results presented in Table Four indicate that years until depletion range from 19 years for scenario three to 30 years for scenario two.

Adequacy of resource for 4% rule under four scenarios
Shock Return Inflation Rate Year Balance goes to $0
None 2.00% 3.00% 23
None 4.00% 3.00% 30
-20% first year 2.00% 3.00% 19
-20% first year 4.00% 3.00% 23

I suspect that these calculations understate the financial risk associated with adherence to the 4.0% rule.   Some analysts suggest that investors who use the 4.0% rule should maintain a larger portion of their portfolio in equites.  I disagree.  The worse case scenario for the 4.0% rule involving poor stock returns in a period of inflation actually occurred during the 1970s.

Initial Balance $100,000
Disb. Rate 4.00%
Rate of return Inflation rate Real Value of initial balance Beginning of year balance Disbursement End of year balance
1 2.00% 3.00% $100,000 $100,000 $4,000 $98,000
2 2.00% 3.00% $103,000 $98,000 $4,120 $95,840
3 2.00% 3.00% $106,090 $95,840 $4,244 $93,513
4 2.00% 3.00% $109,273 $93,513 $4,371 $91,013
5 2.00% 3.00% $112,551 $91,013 $4,502 $88,331
6 2.00% 3.00% $115,927 $88,331 $4,637 $85,460
7 2.00% 3.00% $119,405 $85,460 $4,776 $82,393
8 2.00% 3.00% $122,987 $82,393 $4,919 $79,122
9 2.00% 3.00% $126,677 $79,122 $5,067 $75,637
10 2.00% 3.00% $130,477 $75,637 $5,219 $71,931
11 2.00% 3.00% $134,392 $71,931 $5,376 $67,994
12 2.00% 3.00% $138,423 $67,994 $5,537 $63,817
13 2.00% 3.00% $142,576 $63,817 $5,703 $59,390
14 2.00% 3.00% $146,853 $59,390 $5,874 $54,703
15 2.00% 3.00% $151,259 $54,703 $6,050 $49,747
16 2.00% 3.00% $155,797 $49,747 $6,232 $44,510
17 2.00% 3.00% $160,471 $44,510 $6,419 $38,982
18 2.00% 3.00% $165,285 $38,982 $6,611 $33,150
19 2.00% 3.00% $170,243 $33,150 $6,810 $27,003
20 2.00% 3.00% $175,351 $27,003 $7,014 $20,529
21 2.00% 3.00% $180,611 $20,529 $7,224 $13,715
22 2.00% 3.00% $186,029 $13,715 $7,441 $6,548
23 2.00% 3.00% $191,610 $6,548 $7,664 -$985
24 2.00% 3.00% $197,359 -$985 $7,894 -$8,899
25 2.00% 3.00% $203,279 -$8,899 $8,131 -$17,208
26 2.00% 3.00% $209,378 -$17,208 $8,375 -$25,927
27 2.00% 3.00% $215,659 -$25,927 $8,626 -$35,072
28 2.00% 3.00% $222,129 -$35,072 $8,885 -$44,659
29 2.00% 3.00% $228,793 -$44,659 $9,152 -$54,704
30 2.00% 3.00% $235,657 -$54,704 $9,426 -$65,224

 

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