The 4% rule (withdraw 4% of your portfolio per year, indexed to inflation) has been a cornerstone of retirement planning since its introduction in 1994 by Bill Bengen. To assess its validity in a high-CAPE world, let's examine the original study, updates from Bengen, and research from Michael Kitces.
Bengen's Original Study and Updates
Bengen's study used historical data from 1926 to 1976 to determine the sustainable withdrawal rate for a retiree. Assuming a portfolio with 50% stocks and 50% bonds, he found that a 4% annual withdrawal rate, adjusted for inflation, would provide a 95% success rate for a 30-year retirement period. However, Bengen has since updated his research, citing the impact of low interest rates and high valuations on the 4% rule's validity.
For example, if we consider a $1 million portfolio with a 4% withdrawal rate, the annual income would be $40,000. To calculate the sustainability of this withdrawal rate, we can use the following formula: Withdrawal Amount = Portfolio Value x Withdrawal Rate. Using this formula, we can calculate the portfolio balance over time, assuming an average annual return of 7% and an inflation rate of 3%.
- Year 1: $1,000,000 - $40,000 = $960,000, then $960,000 x 1.07 = $1,027,200
- Year 2: $1,027,200 - $40,000 x 1.03 = $41,200 = $986,000, then $986,000 x 1.07 = $1,054,020
- Year 3: $1,054,020 - $42,408 = $1,011,612, then $1,011,612 x 1.07 = $1,082,373
As we can see, the portfolio balance increases in the first few years, but the withdrawal rate remains the same. This highlights the importance of regularly reviewing and adjusting one's retirement plan to ensure a sustainable income stream.
Kitces's Research: A More Nuanced Approach
Michael Kitces has conducted extensive research on the 4% rule, incorporating more recent data and various market scenarios. His findings suggest that the 4% rule may be too aggressive in today's market environment. Kitces recommends a more dynamic approach, adjusting the withdrawal rate based on the portfolio's performance and the retiree's expenses.
For instance, Kitces suggests using a withdrawal rate based on the portfolio's yield, rather than a fixed percentage. This approach takes into account the current market conditions and can help reduce the risk of depleting the portfolio. To calculate the withdrawal rate based on the portfolio's yield, we can use the following formula: Withdrawal Rate = Portfolio Yield / (1 - Tax Rate). Using this formula, we can determine a more sustainable withdrawal rate based on the current market conditions.
Contemporary Planners' Perspectives
Many contemporary financial planners have moved away from the traditional 4% rule, opting for more personalized and adaptive approaches. Some recommend using a lower withdrawal rate, such as 3.5% or 3%, to account for the current market conditions. Others suggest using a combination of income sources, such as dividends, interest, and capital gains, to reduce the reliance on a single withdrawal rate.
For example, if we consider a $1 million portfolio with a 3.5% withdrawal rate, the annual income would be $35,000. Using the same formula as before, we can calculate the portfolio balance over time, assuming an average annual return of 7% and an inflation rate of 3%.
- Year 1: $1,000,000 - $35,000 = $965,000, then $965,000 x 1.07 = $1,031,550
- Year 2: $1,031,550 - $35,000 x 1.03 = $36,050 = $995,500, then $995,500 x 1.07 = $1,065,485
- Year 3: $1,065,485 - $36,675 = $1,028,810, then $1,028,810 x 1.07 = $1,100,826
As we can see, the portfolio balance increases in the first few years, but the withdrawal rate remains the same. This highlights the importance of regularly reviewing and adjusting one's retirement plan to ensure a sustainable income stream.
For those looking to calculate their own retirement number, tools like the Freedom Calculator can provide a more tailored estimate, taking into account individual circumstances and investment portfolios.
Real-World Implications
The 4% rule's validity is highly dependent on the current market conditions, and retirees should be prepared to adapt their withdrawal strategies accordingly. By using a more dynamic approach, such as adjusting the withdrawal rate based on the portfolio's performance and the retiree's expenses, retirees can reduce the risk of depleting their portfolio and ensure a sustainable income stream.
For example, if we consider a retiree with a $1 million portfolio and an annual expense of $40,000, we can calculate the sustainable withdrawal rate using the following formula: Withdrawal Rate = Annual Expense / Portfolio Value. Using this formula, we can determine the sustainable withdrawal rate and adjust it based on the current market conditions.
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In conclusion, the 4% rule may not be valid in a high-CAPE world, and retirees should consider a more dynamic approach to withdrawal strategies. By using tools like the Freedom Calculator and adjusting the withdrawal rate based on the portfolio's performance and the retiree's expenses, retirees can reduce the risk of depleting their portfolio and ensure a sustainable income stream.
Tools worth looking at
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- Empower — Free net worth tracking, portfolio analysis, and retirement planner. The dashboard serious FIRE chasers actually use.
- Acorns — Round-ups that invest your spare change automatically. The lowest-friction way to start investing if you have been putting it off.
- Wealthfront — Tax-loss harvesting, a 5% cash account, and direct indexing once you cross $100k. Solid robo for the set-and-forget crowd.